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Fundamentals of the Income Taxation of Trusts and Estates AICPA Advanced Estate Planning

Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA July, 2006

What Well Cover


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Structure of Subchapter J Basic Rules Distributable Net Income (DNI) Types of Trusts Trust Accounting Income (TAI) Taxable Income Distribution Deduction/Tier System Separate Share Rule 65 Day Rule Charitable Deductions/Depreciation Terminations Administration Expenses Allocating Expenses to Tax Exempt Income

Income Taxation of Trusts and Estates Code Outline


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PART I, SUBCHAPTER J Subpart A - Sec. 641-646 - General Rules 641 Subpart B - Sec. 651-652 - Simple Trusts 651 Subpart C - Sec. 661-664 - Complex Trusts and CRT 661 Subpart D - Sec/ 665-668 - Accumulation Distributions 665 Subpart E - Sec. 671-678 - Grantor Trusts 671 Subpart F - Sec. 681-685 - Misc. Rules 681PART II, SUBCHAPTER J Sec. 691-692 - Income in Respect of a Decedent 691-

Income Taxation of Trusts and Estates


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Separate Taxable Entities Taxable Income Computed in Same Manner as Individuals (Sec. 641(b)) Own Tax Year and Method of Accounting Receive Income/Pay Expenses Income Taxed to Entity or Beneficiary

Income Taxation of Trusts and Estates


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Income Taxed to Either Entity or Beneficiary

If income is accumulated and not deemed distributed, it is taxed to the trust or estate If income distributed: distributed:
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Trust gets deduction for amount of distribution Beneficiary accounts for income distributed on his own tax return

Income Taxation of Trusts and Estates DNI


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Distributable Net Income (DNI) governs:

Amount of trust or estates distribution deduction estate Amount beneficiary accounts for on his own return Character of income in beneficiarys hands beneficiary

Income Taxation of Trusts and Estates DNI


DNI acts as ceiling on entitys distribution deduction DNI acts as ceiling on amount beneficiary accounts for on his return

Trust/Estate

Beneficiary

DNI - Sec. 643(a)


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Start With Taxable Income and . . .


Add back the distribution deduction Add back the personal exemption Subtract out capital gains/add back capital losses gains/add allocable to principal (except in the year of termination) Subtract out extraordinary dividends and taxable stock dividends Add back net tax-exempt income tax-

DNI - Sec. 643(a)


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Note: capital gains taxed to trust or estate

Exception: year of termination

Note: The rules regarding DNI and the distribution deduction are applied differently to trusts and estates Distributions of principal as well as income will carry out DNI out

Exception: Specific bequests under Sec. 663(a)(1)

Types of Trusts
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Simple Complex Grantor

Simple Trust
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Required to distribute accounting income annually Makes no principal distributions, and Makes no distributions to charity

Complex Trust
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Accumulates income Makes discretionary distributions of income or mandatory or discretionary distributions of principal, or Makes distributions to charity

Grantor Trust
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Grantor or beneficiary has one or more powers powers described in Sec. 673-678 673Result: All income, expenses and credits flow through and are taxed to the Grantor or beneficiary through regardless of whether distributions are made Subpart A-D, Subchapter J (rules for taxation of trusts Aand estates) do not apply to Grantor trusts

Concept of Trust Accounting Income (TAI)


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Governs amount of distributions Trustee allocates receipts/disbursements between accounting income and principal Accounting income and principal is determined by governing instrument or, if instrument silent, by state law

Trust Accounting Income (TAI)


TAI Corp Bond Int Capital Gains Muni Bond Int Expenses ? ? Taxable Income

2006 Fiduciary Income Tax Rates


Over 0 2,050 4,850 7,400 10,050 Not Over 2,050 4,850 7,400 10,050 15% 25% 28% 33% 35%

Taxable Income of Trust or Estate


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Computed same as individual Exemptions: $600/$300/$100 Different rules for charitable deductions Depreciation deduction allocated between entity and beneficiary Distribution deduction Administration expenses - some not subject to 2% floor AGI - same as individual except (a) personal exemption, (2) distribution deduction, (3) charitable deduction and (4) some administration expenses are subtracted off the top, i.e. subtracted from taxable top, income to arrive at AGI

Distributions - Simple Trust


Beneficiary Taxed on Lower of TAI or DNI Gains Taxed to Trust Trust Gets Distribution Deduction Equal to DNI Simple Trust

Gains

DNI
Beneficiary Accounts for DNI Beneficiary

Trust income retains its character in Beneficiarys hands

Distributions - Complex Trusts and Estates


Trust/Estate Accumulates Income

Gains and DNI Taxed to Trust

Complex Trust

Gains DNI

Distributions - Complex Trusts and Estates


Beneficiary Taxed on Distributions Up to DNI Gains Taxed to Trust Trust Gets Distribution Deduction Equal to Distributions up to DNI Complex Trust

Gains

DNI
Beneficiary Accounts for Distributions Up to DNI Beneficiary

Trust income retains its character in Beneficiarys hands

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Distributions - Applicable Code Sections

Simple Trusts

Complex Trusts/ Estates

651

661

652

662

Disributions - Applicable Code Sections

Simple Trusts Distribution Deduction

Complex Trusts/ Estates

651

661

652

662

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Disributions - Applicable Code Sections

Simple Trusts Distribution Deduction Amt Bene Accounts For

Complex Trusts/ Estates

651

661

652

662

Complex Trust and Estates Tier System


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Two tiers: First Tier - Distribution of income required to be distributed currently Second Tier - Distribution of all other amounts paid, credited or required to be distributed

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Complex Trust and Estates Tier System

DNI First Tier Beneficiary

Second Tier Beneficiary DNI is taxed first to FTB and any balance of DNI is taxed to STB

Complex Trust and Estates Tier System - Example Facts: $40,000 DNI and TAI Trust requires A receive 50% of income Trustee makes discretionary distributions of $20,000 to each B and C A is FTB (Gets 50% of $40,000 TAI) B and C are STB (Discretionary Benes)

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Complex Trust and Estates Tier System - Example $40,000 DNI ($20,000) DNI for FTB $20,000 DNI for STB 2 STB $10,000 DNI for Each STB

Complex Trust and Estates Tier System - Example $40,000 DNI

A $20,000 DNI FTB

B $10,000 DNI STB

C $10,000 DNI STB

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Separate Share Rule Solely for purposes of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Effect: Treat multiple beneficiaries of single trust or estate as if each were the sole beneficiary of a single trust solely for determining how much DNI each distribution carries out.

Separate Share Rule Estate has $10,000 DNI for 2004 Two Equal Beneficiaries: A and B Distributes $10,000 to A in 2004 A taxed on $10,000 Estate has $5,000 DNI for 2005 Distributes $10,000 to B in 2005 B taxed on $5,000 Same amount paid in 2 different years, different tax result

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Separate Share Rule Estate has $10,000 DNI for 2004 Two Equal Beneficiaries: A and B Distributes $10,000 to A in 2004 A taxed on $5,000 ($10,000 DNI/2) Estate has $5,000 DNI for 2005 Distributes $10,000 to B in 2005 B taxed on $2,500 ($5,000 DNI/2) DNI computed based on 2 separate shares

Separate Share Rule


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Applies to estates and trusts DNI computed separately for each share Mandatory, not elective Only Affects share of DNI Doesnt allow filing multiple returns Doesnt allow separate calculation of tax

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65 Day Rule aka Sec. 663(b) Election


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Applies to complex trusts and estates Allows fiduciary to treat distribution made within 65 days of Y/E as being made on 12/31 of preceding year Election must be made by due date of return Election is irrevocable Year by year election (e.g. good for 1 year only) Limited to > DNI less current year distributions or TAI not distributed

65 Day Rule aka Sec. 663(b) Election

65 Days 2005 12/31 2006

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65 Day Rule aka Sec. 663(b) Election Facts: $10,000 DNI for 2005 Distributes $6,000 in 2006 $4,000 65 Days $6,000 2005 12/31 2006

Specific Bequests - Sec. 663(a)(1)


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Bequest of specific sum of money or specific property do not carry out DNI Requirements: Paid all at once, or Paid in not more than 3 installments Not taxable by trust/estate or taxable to bene

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Charitable Deduction - Sec. 642(c)


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Requirements: Paid from gross income Paid pursuant to the governing document Unlimited in amount No distribution deduction Taken as deduction in computing AGI Generally, must be actually paid in current year or preceding year Estates and pre- 1969 trusts get charitable prededuction if permanently set aside aside

Depreciation - Sec. 642(e)


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Trusts: Depreciation apportioned between income bene and the trust per trust document If no provisions in trust, depreciation apportioned on basis of trust income allocable between bene and trust Estates: Depreciation allocable on basis of income allocable to bene and estate

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Depreciation - Sec. 642(e) Example


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Facts: Trust owns apartment building $2,500 depreciation deduction Trust pays all income to beneficiary Beneficiary is entitled to entire $2,500 depreciation deduction

Depreciation - Sec. 642(e) Exceptions


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GR: Depreciation allocated based in TAI allocated to trust/estate and beneficiary 2 exceptions - both apply to trusts: Trust inst or local law indicates who get depreciation deduction Trustee maintains depreciation reserve, trust gets deduction to extent trustee transfers income to reserve for depreciation

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Depreciation - Sec. 642(e) Example


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Facts: Depreciation deduction is $5,000 TAI is $20,000 Inst requires trustee to maintain depr reserve Trustee transfers $5,000 of income for depr reserve Result: Entire $5,000 depr deduction is allocated to trust

Termination of Trusts and Estates - Sec. 642(h) Unused Loss Carryovers and Excess Deductions
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NOL, capital loss c/o and excess deductions pass to deductions the beneficiary on termination of an estate or trust Pass through only in the year of termination

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Capital Loss C/O


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Unused capital loss c/o passes to beneficiary in year of termination of trust or estate No time limit on beneficiary to use capital loss c/o

Capital Loss C/O Example


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Facts: Trust incurs $30,000 LTCL in 2004. Trust terminates in 2005, LTCL c/o still $30,000 $30,000 LTCL c/o passes to beneficiary on termination Beneficiary can use LTCL c/o to offset his own personal capital gains or, if he has no gains, deduct up to $3,000 each year against ordinary income

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Excess Deductions
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Excess deductions occur where trust/estate expenses deductions exceed income in year of termination Excess deductions pass through to beneficiary on deductions termination of trust/estate

Beneficiary can deduct on his personal return

Deductible as miscellaneous itemized deduction subject to 2% floor

If beneficiary doesnt itemize, he cant use deduction doesn can

Excess Deductions Example


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Facts: Estate has $30,000 of income and $50,000 executors executor fee for 2005. Estate terminates in 2005 Excess deductions are $20,000 ($30,000 - $50,000) deductions Estate reports the $20,000 excess deduction to the beneficiary on a Form K-1 (tax letter) K- ( letter Beneficiary can take $20,000 excess deduction on deduction his own personal return as a miscellaneous itemized deduction subject to the 2% floor

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Administration Expenses
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Consist of attorneys fees, accountants fees, executors attorney accountant executor commissions, filing fees, surety bonds premiums, appraisal fees, etc. Deductible on Federal estate tax return (706) or fiduciary income tax return (1041), but not both Fiduciary can elect where to take expenses (706 or 1041) - the so-called Sec. 642(g) election soGenerally, not subject to 2% floor Test: expenses would not have been incurred if property not held by estate or trust i.e. expenses are unique to the administration of estate or trust Generally, claim on return with highest tax rate

Non-Deductible Expenses - Sec. 265


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Sec. 265 disallows any deduction attributable to T/E income Generally applies to deductions for production of income, usually trustees fees and executors fees trustee executor If trust/estate has T/E income, portion of trustees and trustee executors fees are nondeductible executor No specific allocation formula Fiduciary can use any reasonable method

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Non-Deductible Expenses - Sec. 265 Example


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Facts: Trust has $30,000 taxable interest and $10,000 T/E interest Incurs $20,000 trustee fee Portion of trustee fee attributable to T/E income is non-deductible non-

$10,000 T/E income $40,000 Total income

x $20,000 fees = $5,000 Non-deductible Non-

Resources
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Federal Income Taxation of Estates, Trusts and Beneficiaries, 3rd Edition by Ferguson, Freeland and Beneficiaries, Ascher (Aspen/CCH) 1041 Deskbook (Practitioners Publishing Co) Income Taxation of Trusts and Estates, 852-2nd (BNA Estates, 852portfolio Estate, Gift and Trust series) Federal Income Taxation of Decedents, Estates and Trusts, 21st Edition (CCH) Trusts, Federal Income Taxation of Trusts and Estates, by Estates, rd Edition (RIA/Thompson/West) Zaritsky and Lane, 3 Income Taxation of Fiduciaries and Beneficiaries by Abbin, 2 volumes, 2006 Edition (CCH) Abbin,

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Example of a 2005 Fiduciary Income Tax Return for a Complex Trust

Facts
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Trust provides that 50% of the income must be paid currently to Will During 2005 the trustee makes the following discretionary distributions: 25% of the income to Cam 25% of the income to charity No reserve for depreciation is required

Question: What type of trust is this and why?

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

Distribution of Income

Required:

50% to Will

Discretionary: 25% to Cam 25% to Charity

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

(14,000) (2,000)

69,000

INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

(14,000) (2,000)

69,000

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

(14,000) (2,000)

Enter on Form 1041, Sch. B, Line 8

69,000

Amount of TAI Received by Each Beneficiary

Will: Cam:

50% x 69,000 TAI = 34,500 25% x 69,000 TAI = 17,250

Charity: 25% x 69,000 TAI = 17,250 Total 69,000

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

Enter on Form 1041, Page 1, Line 17

69,000

47,223

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

Depreciation Deduction
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No reserve for depreciation Depreciation follows accounting income All accounting income is distributed to Will, Cam and the charity Therefore, the trust is not entitled to deduct any depreciation Beneficiaries are entitled to depreciation deduction

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INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

Trustee Fee Allocable to T/E Income

15,000 T/E Income x 3,000 Total 85,000 Gross TAI Tr Fees

529

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Trustee Fee Allocable to T/E Income

15,000 T/E Income x 3,000 Total = 529 85,000 Gross TAI Tr Fees Non-Deductible Deductible Tr Fees (529) 2,471

INCOME Rents Tax Int. T/E Int LTCG EXPENSES Depr/Rental R/E Rent Ex Tr Fee-Prin Tr Fee-Inc Char Ded Exemption Total 6,000 14,000 1,000 2,000 40,000 30,000 15,000 8,000

TAI 40,000 30,000 15,000 -

TI 40,000 30,000 8,000 78,000

(14,000) (2,000)

(14,000) (2,471) (14,206) (100)

69,000

47,223

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Trustee Fee Allocable to T/E Income

15,000 T/E Income x 17,250 TAI = 3,044 85,000 Gross TAI Charity Non-Deductible Charitable Deduction 3,044 14,206

Calculation of DNI
DNI TI before Dist Ded Add: Exemption Add: Net T/E Income Less: ND Tr Fee Less: ND Char Ded Less: LTCG DNI 15,000 (529) (3,044) 11,427 (8,000) 50,750 47,223 100

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Calculation of DNI
DNI TI before Dist Ded Add: Exemption Add: Net T/E Income Less: ND Tr Fee Less: ND Char Ded Less: LTCG DNI 15,000 (529) (3,044) 11,427 (8,000) 50,750 47,223 100

Enter on Form 1041, Sch. B, Line 7

Components of DNI
47.06% 35.29% 17.65% Rental Taxable T/E Income Interest Interest 40,000 30,000 15,000 (14,000) (1,412) (8,118) 16,470 (1,059) (6,088) 22,853 (529) 11,427

Gross TAI LESS: Rental Exp Tr. Fees Char Ded Totals

100% Total 85,000 (14,000) (3,000) 50,750

(3,044) (17,250)

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Application of the Tier System


Will is a FTB - entitled to 50% of the income or $34,500 Cam is a STB - discretionary distribution of $17,250 How do we allocate DNI between FTB and STB???

Now Weve Got a Problem!!!


FTB Will gets distribution of Total Distributions $34,500 $51,750

STB Cam gets distribution of $17,250

But DNI is only $50,750!!!

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The Tier System Solves Our Problem


Share of DNI FTB Will - Receives $34,500; limited to DNI of $50,750 STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250 Total (Equal to DNI) $34,500

$16,250 $50,750

The Tier System Solves Our Problem


Share of DNI FTB Will - Receives $34,500; limited to DNI of $50,750 STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250 Total (Equal to DNI) $34,500 % of DNI 67.98

$16,250 $50,750

32.02 100

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Remember This??? Components of DNI


47.06% 35.29% 17.65% Rental Taxable T/E Income Interest Interest 40,000 30,000 15,000 (14,000) (1,412) (8,118) 16,470 (1,059) (6,088) 22,853 (529) 100% Total 85,000 (14,000) (3,000)

Gross TAI LESS: Rental Exp Tr. Fees Char Ded Totals

(3,044) (17,250) 11,427 50,750

Will and Cam get 67.98% and 32.02%, respectively, of each of these items

Trustee reports these amounts to Will and Cam on separate K-1s


67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536 7,768 34,500 32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

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Will Reports $26,731 of TI

67.98% Will Rental Income 31 11,196 Taxable 26,7 Interest $ 15,536 T/E Interest 7,768 Total 34,500

32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

Cam Reports $12,592 of TI


67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536$ 7,768 34,500 32.02% Cam

Total 16,470 22,853 11,427 50,750

2 ,5 9 2

5,274 7,317 3,659 16,250

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But . . Arent We Missing Something??? Will Reports Taxable Income $26,731 Cam Reports $12,592

YES! - Depreciation
Will Reports Taxable Income Depreciation $26,731 (3,000) Cam Reports $12,592 (1,500) $11,092

Net Taxable Income $23,731

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Wheres the Other $1,500 of Depreciation?


Will Reports Taxable Income Depreciation $26,731 (3,000) Cam Reports $12,592 (1,500) $11,092

Net Taxable Income $23,731

It is Allocated to Charity and is Wasted!!!

The Distribution Deduction is $39,323

67.98% Will Rental Income Taxable Interest T/E Interest Total 11,196 15,536 7,768 34,500

32.02% Cam 5,274 7,317 3,659 16,250

Total 16,470 22,853 11,427 50,750

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Trusts Taxable Income TI Before Dist Deduction $47,223 Distribution Deduction Taxable Income $39,323 $7,900

The taxable income is the LTCG less the $100 exemption

Trusts Taxable Income TI Before Dist Deduction $47,223 Distribution Deduction Taxable Income $39,323 $7,900

Report on Form 1041, Page1, Line22

The taxable income is the LTCG less the $100 exemption

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Summary
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Compute TAI Figure Distribution Beneficiaries Get Calculate Taxable Income Allocate Depreciation Allocate Expenses to T/E Income Calculate DNI Apply Tier System Allocate DNI Send K-1s to Beneficiaries KComplete 1041

Thank God for Tax Software!!!

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Income Tax Consequences of Funding Bequests


Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March 7, 2006

Funding Bequests In Kind - 6 Issues


1 2 3 4 5 6 Does the distribution carry out DNI? If DNI carried out, how much? Is the Estate/Trust required to recognize gain? Can the Estate/Trust elect to recognize gain? What is the basis of property to distributee beneficiary? What is the holding period for distributee beneficiary?

Facts
Funding trust makes a specific bequest of $100,000 painting to A Funding trust distributes balance to marital and family trust Marital is pecuniary formula bequest and family trust is residuary bequest Value of Funding trust is $2,100,000 Marital and family trust each get $1,000,000 Fund both trusts in-kind with 25,000 shares of Mellon stock Basis of Mellon stock: $20/sh FMV of Mellon stock: $40/sh Mellon shares have long-term holding period in funding trust Painting distributed to A and marital trust funded in 2003 Family trust funded in 2004 Funding trust DNI is $150,000 in 2003, $75,000 in 2004 Separate share rule applies

2003 DNI = $150,000

Funding Trust

$100,000 Painting 50,000 sh Mellon stock - $40/sh FMV ($2,000,000) - $20/sh Basis ($1,000,000)

$100,000 Painting to A

Marital Trust
$1MM Pecuniary Bequest

Family Trust
$1MM Residuary Bequest

2003 DNI = $150,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

Marital Trust

Family Trust

$1MM Residuary Bequest

Basis $100,000 HP HP Carryover

2003 DNI = $150,000

Funding Trust

Each trust gets 25,000 sh of Mellon stock with FMV of $1,000,000 and basis of $500,000

$100,000 Painting to A

Marital Trust
$1MM Pecuniary Bequest

Family Trust
$1MM Residuary Bequest

2003 DNI = $150,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

Marital Trust

Family Trust

$1MM Residuary Bequest

75,000

$ 500,000 $1,000,000 New HP

Basis $100,000 HP HP Carryover

DNI = $150,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

$500,000 gain taxed to Funding Trust Family Trust


$1MM Residuary Bequest

Marital Trust

75,000

$ 500,000 $1,000,000 New HP

Basis $100,000 HP HP Carryover

Section 643(e) Election (Residuary Bequests)


Estate/Trust may elect, but is not required, to recognize G/L Distribution carries out DNI, but amount of DNI depends on whether the Section 643(e) election was made No Election: DNI carried out is lesser of basis or FMV of distributed property Election: DNI carried out is FMV of distributed property Basis of property to beneficiary is basis of property to estate/trust plus or minus any gain or loss the estate/trust elects to recognize on the distribution

2004 DNI = $75,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

Marital Trust

Family Trust No 643(e)

$1MM Residuary Bequest

75,000

$ $ 75,000 No Gain $ 500,000 HP Carryover

$ 500,000 $1,000,000 New HP

Basis $100,000 HP HP Carryover

2004 DNI = $75,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

Marital Trust

Family Trust No 643(e)

$1MM Residuary Bequest

643(e) $ 75,000 $ 500,000 $1,000,000 HP Carryover

75,000

$ $ 75,000 No Gain $ 500,000 HP Carryover

$ 500,000 $1,000,000 New HP

Basis $100,000 HP HP Carryover

2004 DNI = $75,000

Funding Trust $100,000 Painting to A DNI Gain 0 0


$1MM Pecuniary Bequest

Marital Trust

Family Trust No 643(e)

$1MM Residuary Bequest

643(e) $ 75,000 $ 500,000 $1,000,000 HP Carryover

75,000

$ $ 75,000 No Gain $ 500,000 HP Carryover

$ 500,000 $1,000,000 New HP

Basis $100,000 HP HP Carryover

Gain taxed to family trust. Reason: year of termination of Funding Trust so gains are included in DNI and passed out to the beneficiary

Conclusion Funding Bequests In Kind - 6 Issues


1 2 3 4 5 6 Does the distribution carry out DNI? If DNI carried out, how much? Is the Estate/Trust required to recognize gain? Can the Estate/Trust elect to recognize gain? What is the basis of property to distributee beneficiary? What is the holding period for distributee beneficiary?

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INCOME TAX CONSEQUENCES OF FUNDING BEQUESTS Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March, 2006 CONTENTS I. II. III. IV. V. Introduction Distribution System and Separate Share Rule Types of Distributions Six Income Tax Issues Discussion of the Six Income Tax Issues for Each of the Four Types of Distributions A. Bequest or Devise of Specific Property B. Bequest of Specific Sum of Money Ascertainable at Focal Date C. Bequest of Specific Dollar Amount Not Ascertainable at Focal Date D. Residuary Bequest VI. VII. Nonrecognition of Loss IRC 267 Funding a Bequest with Income in Respect of a Decedent (IRD) 38-2 38-2 38-3 38-3

38-4 38-4 38-6 38-8 38-10 38-15 38-16

A. Allocation of IRD and the 691(c) Deduction When IRD is Payable to an Estate or Trust 38-16 B. Transfer of Right to IRD C. Coordination with the Separate Share Rule D. Funding a Pecuniary Bequest with IRD E. Funding a Bequest with Installment Obligations VIII. Conclusion 38-17 38-18 38-21 38-22 38-23

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INCOME TAX CONSEQUENCES OF FUNDING BEQUESTS Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA March, 2006

I. INTRODUCTION At some point during the administration of an estate or trust, the fiduciary will make one or more distributions from the estate or trust to the beneficiaries. The income tax consequences of the distributions are discussed in this article. As discussed below, there are four types of distributions. Each type of distribution raises six income tax issues that must be addressed. The fiduciary must classify the distribution as one of the four types discussed below and then address the six income tax issues for that type of distribution.

The first section of this outline discusses the distribution system of estates and trusts. The next section discusses the four types of distributions. Next, the six income tax issues that arise when a distribution is made are discussed. The discussion then turns to a detailed analysis of the six income tax issues for each type of distribution. The final two sections discuss the application of 267, which disallows the recognition of a loss on a sale or exchange between related parties, and funding bequests with income in respect of a decedent and installment notes. II. DISTRIBUTION SYSTEM AND SEPARATE SHARE RULE The distribution system for trusts and estates is governed primarily by four sections of the Internal Revenue Code. Generally speaking, an estate or trust is entitled to a distribution deduction for the amount it distributes to its beneficiaries (limited to distributable net income or DNI) and the beneficiaries are required to account for the distribution on their income tax returns (limited by DNI). Simple trusts are governed by 651 and 652. Estates and complex trusts are governed by 661 and 662. The amount of the distribution deduction is governed by 651 for simple trusts and 661 for estates and complex trusts. The amount that a beneficiary must account for on his income tax return is governed by 652 for simple trusts and 662 for estates and complex trusts. Distributions by estates and complex trusts may be either a required distribution (referred to as a first tier distribution) or a discretionary distribution (referred to as a second tier distribution). First tier (mandatory) distributions are governed by 661(a)(1) and 662(a)(1). Second tier (discretionary) distributions are governed by 661(a)(2) and 662(a)(2). The amount of DNI carried out to beneficiaries of an estate or trust may be limited by the separate share rule. If a single trust has more than one beneficiary and if different beneficiaries have substantially separate and independent shares, their shares are treated separately for the sole purpose of determining the amount of DNI allocable to the beneficiaries under 661 and 662.1 Thus, the effect of the separate share rule is to treat multiple beneficiaries of a single trust or

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estate as if each were the sole beneficiary of a single trust for the purposes of determining how much DNI each distribution carries out. The separate share rule prevents one trust or estate beneficiary who receives a distribution from receiving more than his pro-rata share of DNI. If separate shares exist, DNI is computed separately for each share.2 After the fiduciary has identified the separate shares, the fiduciary must allocate the items of income and deductions among those shares to compute the DNI for each share. In computing DNI for each separate share, the portion of gross income that is income under 643(b) must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable local law.3 In reviewing the material below, it must be kept in mind that the amount of DNI carried out to a particular beneficiary may be governed by the application of the separate share rule.4 A specific bequest as defined in 663(a)(1) falls outside the traditional distribution system the estate or trust is not entitled to a distribution deduction and the beneficiary is not required to account for the distribution on his income tax return. III. TYPES OF DISTRIBUTIONS There are four possible types of distributions, each of which have different income tax consequences. The four types of distributions are as follows: 1. A distribution of specific property, a particular identifiable item ascertainable under the terms of the instrument e.g. I leave my pink Cadillac to my son, Bruce.5 2. A distribution of a specific sum of money, the amount of which is ascertainable on the focal date (usually the date of the decedents death) e.g. I leave $10,000 to my aunt, Edna. 6 3. A bequest of a specific dollar amount that is not ascertainable on the focal date (usually the date of the decedents death) but becomes ascertainable before distribution.7 The most common example of this type of bequest is a pecuniary formula marital deduction bequest e.g. I leave to my spouse the minimum amount needed to reduce my Federal estate tax to zero. The identity of the property and the amount of the bequest remains unascertained until the fiduciary makes certain decisions regarding tax elections after the focal date.8 For example, the amount of the formula marital deduction is dependent on the executors discretion and on the election to deduct the payment of administration expenses on the estate tax return or the fiduciary income tax return, which are not facts existing on the date of the decedents death. 4. A residuary bequest e.g. I leave all the rest, residue and remainder of my estate to my cousin, Vinny. IV. SIX INCOME TAX ISSUES Whenever an estate or trust makes a distribution to a beneficiary, there are six income tax issues that must be addressed:

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1. Does the distribution carry out distributable net income (DNI)? 2. If the distribution carries out DNI, how much DNI does it carry out? 3. If the distribution is made in-kind (i.e. property rather than cash), is the estate or trust required to recognize gain or loss on the distribution? 4. If the distribution is made in-kind and the estate or trust is not required to recognize gain or loss, may it elect to recognize gain or loss? 5. If the distribution is made in-kind, what is the basis of the property in the hands of the distributee beneficiary? 6. If the distribution is made in-kind, what is the holding period of the property in the hands of the distributee beneficiary? V. DISCUSSION OF THE SIX INCOME TAX ISSUES FOR EACH OF THE FOUR TYPES OF DISTRIBUTIONS The following discussion assumes an estate or trust with DNI in excess of the aggregate distributions. A distribution carries out DNI only to the extent that the estate or trust has DNI. A. Bequest or Devise of Specific Property 663(a)(1) is an exception to the 661 and 662 rules governing distributions from estates and complex trusts. If a distribution meets the requirements of 663(a)(1), the estate or trust is not entitled to a distribution deduction under 661 and the beneficiary is not required to include the distribution in income under 662. 663(a)(1) states that any amount which, under the terms of the governing instrument, is properly paid or credited as a gift or bequest of a specific sum of money or of specific property and which is paid or credited all at once or in not more than three installments falls outside the distribution rules of 661(a) and 662(a) i.e. the distribution does not carry out DNI. Three requirements must be met for a distribution to qualify under 663(a)(1). First, the distribution must be of specific property or a specific, pecuniary sum of money. The regulations indicate that a gift or bequest is specific if the amount of money or the identity of the property is ascertainable under the terms of the testators will as of the date of death or under the terms of an inter vivos trust instrument as of the date of the inception of the trust.9 Second, the distribution must be paid either all at once or in not more than three installments.10 Third, 663(a)(1) provides that a distribution is not considered to be a gift or bequest of a specific sum of money if it can be paid only from income.11 Under 663(a)(1), the distribution of the actual property bequeathed will not carry out DNI so long as the terms of the bequest do not require payment of the bequest in more than three installments and the bequest is not required to be paid out of income of the estate or trust.12 Reg. 1.663(a)-1(c)(1)(iv) states that the number of installments required by the trust instrument governs regardless of the number of installments actually made. In addition, Reg. 1.663(a)-(1)(c) further refines the application of the three installment rule.

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The income tax results are as follows: a. Under 663(a)(1) the bequest or devise of specific property does not carry out DNI. The distributee beneficiary does not include the value of the distribution in his gross income and the estate or trust does not receive a distribution deduction.13 b. The estate or trust is not required to recognize gain or loss on the distribution.14 c. The 643(e) election does not apply to a distribution under 663(a)(1). Thus, the fiduciary may not elect to recognize gain or loss on the distribution.15 d. The basis of the property in the hands of the distributee beneficiary is the estate or trusts basis i.e. there is a carryover basis.16 e. The distributee has an automatic long-term holding period.17 Example: Decedents will says, I leave my grand piano to my niece, Mildred. The bequest of the grand piano is a bequest of specific property under 663(a)(1). As a result, Mildred is not required to include the value of the grand piano in her income and the estate does not get a distribution deduction for the value of the grand piano. Since the specific property left to Mildred is, in fact, being distributed to her, the estate does not, and may not elect to, recognize gain or loss on the difference between the fair market value and the estates basis in the piano. Mildred takes the estates basis in the grand piano. Mildred is deemed to have held the piano for the long-term holding period. If the fiduciary distributes property other than that actually bequeathed or devised, there is still no DNI carried out to the beneficiary but the gain or loss results are different. a. Under 663(a)(1) the bequest or devise of specific property does not carry out DNI. The distributee beneficiary does not include the distributed property in his gross income and the estate or trust does not receive a distribution deduction.18 b. The estate or trust must recognize gain if it distributes appreciated property (property with a fair market value greater than its basis) or loss if it distributes depreciated property (property with a fair market value less then its basis).19 The bequest is treated for tax purposes as if the estate or trust distributed the actual property bequeathed and then exchanged it for the other property distributed.20 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. c. The estate or trusts recognition of gain or loss is mandatory, not elective.21 d. The basis of the distributed property in the hands of the distributee beneficiary is its fair market value at the time of distribution.22 Since the gain is required to be recognized as a result of the distribution, the distributed property receives a basis equal to the fair market value on the date of distribution.23 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties.

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e. The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2).24 Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of 1223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution. Example: Decedents will says, I leave my grand piano to my niece, Mildred. Instead of distributing the grand piano to Mildred, the executor distributes an antique table of equivalent value. The distribution of the antique table falls under the general rule of 663(a)(1). Thus, Mildred is not required to include the value of the antique table in her income, and the estate does not get a distribution deduction for the value of the antique table. However, unlike the previous example, the estate is required to recognize gain on the difference between the fair market value of the antique table and its basis to the estate due to the fact that the distribution was of property other than the property specifically left to Mildred. Mildred would take a basis in the antique table equal to its fair market value as of the date of distribution. Mildreds holding period in the antique table would commence on the day after the table was distributed to her i.e. the holding period starts anew in Mildreds hands. B. Bequest of Specific Sum of Money Ascertainable at Focal Date. If the fiduciary makes a distribution of cash to satisfy a distribution of a specific sum of money, the amount of which is ascertainable at the focal date (usually the date of death), the income tax results are as follows: a. The bequest of a specific sum of money which is ascertainable at death is not included in the beneficiarys income and the estate or trust does not receive a distribution deduction if the governing instrument does not require payment of the bequest in more than three installments and the governing instrument does not require that the bequest be satisfied out of income.25 If the governing instrument does not specify a time for the payment of the bequest, any payments are treated as required to be paid in a single installment.26 b. The estate or trust is not required to recognize gain or loss.27 c. The 643(e) election doesnt apply to distributions of cash. Thus, the estate or trust cannot elect to recognize gain or loss. d. Cash has a basis equal to its denomination. e. The holding period of cash is not an issue.

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Example: Decedent leaves $10,000 in her will to her nephew, Thaddeus. Since the bequest is ascertainable at the date of the decedents death, Thaddeus is not required to report any of the $10,000 in his income and the estate does not get a distribution deduction for the $10,000 distribution. Example: Instead of leaving a specific sum of money, the decedent leaves an amount of money equal to the date of death value of her grand piano to her nephew, Thaddeus. The tax results are the same as in the preceding example.28 Example: Decedents will leaves $100,000 to Ozzie. After paying all debts and administration expenses, the estate has only an asset having a FMV of $80,000 and a basis of $50,000. The asset is transferred to Ozzie in satisfaction of the $100,000 bequest. The bequest is still governed by 663(a)(1). Although the full amount of the bequest cannot be satisfied, the bequest is not transformed into a residuary bequest. Thus, satisfying the bequest with the asset does not result in taxable income to the beneficiary or result in a distribution deduction for the estate. However, the estate must recognize gain of $30,000 ($80,000 FMV less $50,000 basis). The basis of the asset to the beneficiary is $80,000, the FMV of the asset. The holding period of the assets appears to begin the day after the acquisition by the beneficiary. If instead of distributing cash, the fiduciary makes a distribution of property in lieu of the specific sum of money bequeathed, there is still no DNI carried out to the beneficiary but the gain or loss results are different. The income tax results are as follows: a. The distributee beneficiary is not required to include the value of the property in his gross income and the estate or trust does not receive a distribution deduction.29 b. The estate or trust must recognize gain or loss on the distribution if the fair market value of the property exceeds or is less than its basis.30 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. c. The estate or trusts recognition of gain or loss is mandatory, not elective.31 d. The basis of the distributed property in the hands of the distributee beneficiary is the propertys fair market value at the date of the distribution.32 Since the gain is required to be recognized as a result of the distribution, the distributed property receives a basis equal to the fair market value on the date of distribution. See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. (e) The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2). Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of

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1223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution. If a bequest is delayed and the beneficiary is entitled to interest on the bequest pursuant to state law, the payment will be interest paid or incurred by the estate pursuant to 163 and gross income to the beneficiary pursuant to 61(a)(4).33 Pursuant to Rev. Rul. 73-322, 661 and 662 do not apply because the relationship between the parties is that of debtor and creditor rather than of estate or trust and income beneficiary. The final separate share regulations come to the same conclusion. Thus, the payment of interest on the late payment of a pecuniary bequest results in no DNI being carried out from the estate to the beneficiary. The interest payment is taxable income to the beneficiary under the general rule of Section 61. The estate treats the interest payment as personal interest that is not deductible by the estate under Section 163(h).34 Note that this treatment may result in double taxation the beneficiary reports the interest income and the estate receives no deduction for the payment because it is nondeductible personal interest and, in addition, does not qualify for a distribution deduction. C. Bequest of Specific Dollar Amount not Ascertainable at Focal Date. If the fiduciary makes a distribution of a cash to satisfy a distribution of a specific dollar amount, the amount of which is not ascertainable at the focal date (usually the date of death), the income tax results are as follows: a. The distribution carries out DNI. 663(a)(1) does not apply unless the distribution is ascertainable as of the focal date (usually the date of death).35 The beneficiary must include the distribution in his income and the estate or trust may deduct the distribution, subject to the rules of 661 and 662. b. The estate or trust is not required to recognize any gain or loss. c. The 643(e) election doesnt apply to distributions of cash. d. Cash has a basis equal to its denomination. e. The holding period is not an issue. Note that although a bequest of a specific dollar amount includes bequests of a specific sum of money, for DNI purposes there is a distinction between a specific sum of money bequest, the dollar amount of which is ascertainable at death, and all other specific dollar amount bequests, the dollar amount of which is not ascertainable at death. The regulations under 663 state that a distribution is not a bequest of a specific sum of money or of specific property (and thus not governed by 663(a)(1)) if the amount of money or the identity of the property is ...dependent both on the exercise of the executors discretion and on the payment of administration expenses and other charges, neither of which are facts existing on the date of the decedents death.36 The regulation goes on to state that, It is immaterial that the value of the bequest is determinable after the decedents death before the bequest is satisfied...37 The most common example of a bequest of a specific dollar amount that is not a bequest of a specific sum of money is a pecuniary

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formula marital bequest. The amount of money needed to satisfy the pecuniary formula marital bequest remains unascertained until the administrator of the estate exercises his or her discretion with respect to certain deductions and distributions.38 Example: Decedents will leaves Jasper a sum of money equal to 10% of his adjusted gross estate as defined in 6166(b)(6) (gross estate less deductions allowed under 2053 and 2054). The amount Jasper will receive is not ascertainable as of the decedent's death. This is due to the fact that the executor may elect to claim administration expenses either as an estate tax deduction or a fiduciary income tax deduction. Thus, the base amount of the adjusted gross estate is not ascertainable until that election is made at some point after the decedents death i.e. the base amount is not ascertainable as of the date of the decedents death. The distribution carries out DNI to Jasper and the estate will receive a corresponding income distribution deduction. If instead of distributing cash, the fiduciary makes a distribution of property in lieu of the specific sum of money bequeathed, the income tax results are as follows: a. The distribution carries out DNI equal to the fair market value of the property at the date of distribution. 663(a)(1) doesnt apply. The distributee beneficiary must include the fair market value of the property in his gross income and the estate or trust gets a distribution deduction equal to the fair market value of the property, subject to the distribution rules of 661 and 662. b. The estate or trust must recognize gain if it funds a pecuniary bequest by distributing property with a fair market value in excess of its basis. 39 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties c. The estate or trusts recognition of gain or loss on funding a pecuniary bequest with appreciated property is mandatory, not elective.40 d. The basis of the property to the distributee beneficiary is the propertys fair market value at the date of distribution.41 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. (e) The holding period does not appear to tack. The length of the holding period is governed by 1223(2). 1223(2) states that the period property is held by the transferor is tacked onto the transferees holding period if the property has the same basis in whole or part in [the transferees] hands as it would have in the hands of the [transferor]. If the transferors basis was the starting point in computing the transferees basis, the transferees basis was the same in part as the transferors and the holding period tacks under 1223(2). Since the property takes a basis of its fair market value as a result of the trust paying a tax on the gain, a literal reading of 1223(2) would prohibit a tacking of the transferors holding period. In this case the estate or trust is deemed to have sold the property to the beneficiary so it would be logical to treat the beneficiary as a purchaser under the tacking rules. As a result, the beneficiarys basis is not determined, in whole or in part, by the trust or estates basis. Thus, 1223(2) is inapplicable and the beneficiarys holding period begins the day after the distribution.

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Example: The classic example of this situation is a pecuniary formula marital deduction bequest e.g. an amount equal to the smallest amount which will result in the lowest possible federal estate tax. A formula marital deduction bequest does not qualify as a specific bequest under 663(a)(1). The amount of the bequest is not ascertainable at the date of death due to the fact that post-death tax elections are available to the executor that may change the amount of the bequest. Thus, the distribution rules of 661 and 662 apply. Although the marital deduction amount is a specific dollar amount or specific property, the identity of the property and the amount are dependent on the exercise of the fiduciarys discretion and on the payment of administration expenses or other charges, neither of which are ascertainable on the date of the decedents death (as is required for the qualification as a specific bequest by Reg. 1.663(a)-1(b)(1)). Thus, distributions to the surviving spouse or the marital deduction trust will carry out DNI. Satisfaction of a pecuniary marital deduction amount with appreciated or depreciated property will result in recognition of gain or loss (subject to the rules of 267) to the distributing entity, with a corresponding adjustment to the basis of the asset in the hands of the surviving spouse or trust equal to the propertys fair market value. Since the propertys basis in the hands of the distributee is its fair market value, the propertys holding period starts anew as of the day after the date distributed to the beneficiary. D. Residuary Bequest A residuary bequest is a bequest of the value of the assets left over after the payment of all expenses and other distributions. The regulations under 663 state residuary bequests do not qualify as tax-free specific bequests.42 Instead, residuary bequests are subject to the normal distribution applicable to estate and trusts A common form of a residuary bequest is a fractional formula marital deduction clause that essentially leaves to the surviving spouse an amount equal to a fraction of the residue of the estate. The pro rata funding of a fractional marital deduction formula clause will not result in gain or loss to an estate or trust. The fractional share is not a pecuniary amount.43 Residuary distributions funded in kind are more complicated44 and, as a result, give the fiduciary a greater opportunity for planning. The income tax consequences of funding a residuary distribution with property are governed by 643(e). 643(e) was enacted by the Tax Reform Act of 1984 to close a loophole in the law that allowed an estate or trust to fund a residuary bequest with appreciated property without having to recognize any gain. Under the old law, funding a residuary bequest with appreciated property gave the distributee beneficiary a basis in the distributed property equal to the fair market value of the property at the date of distribution so that the distribution would step up the propertys basis without requiring the estate or trust to recognize gain on the distribution of the appreciated property.45 As a result, the Tax Reform Act of 1984 changed the law by adopting 643(e). Under current law, when an estate or trust distributes property in-kind, 643(e)(3) allows the fiduciary to elect to treat the distribution as a sale to the beneficiary and recognize gain or loss on the distribution.46 Because the above loophole affected only residuary bequests, the legislative history of the Tax Reform Act of 1984 indicates that 643(e) apparently applies only to residuary bequests.47 Reg.

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1.661(a)-2(f) continues to apply to funding bequests of specific property and specific dollar amounts with property. Pursuant to Reg. 1.661(a)-2(f) and Reg. 1.1014-4(a)(3) gain or loss will be recognized and the property in the hands of the distributee beneficiary will receive a basis equal to the fair market value of the property as of the date of distribution, subject to the rules denying loss recognition in related party transactions, discussed below. The rules for the distribution of property in kind to fund a residuary bequest under 643(e) may be summarized as follows: i. The distributing estate or trust may elect, but is not required, to recognize gain or loss as if the property had been sold at its fair market value to the distributee.48 ii. The distributed property carries out DNI to the beneficiary but the amount of the DNI depends upon whether the estate or trust elects to recognize gain or loss.49 iii. The basis of the distributed property to the distributee beneficiary is equal to the basis of the property in the hands of the estate or trust plus or minus any gain or loss the estate or trust elects to recognize on the distribution.50 The income tax consequences of funding residuary distributions with cash are relatively straightforward. a. The distribution carries out DNI. 663(a)(1) does not apply to residuary bequests.51 The distributee beneficiary must include the cash in his gross income and the estate or trust gets a distribution deduction, subject to the rules of 661 and 662. b. The estate or trust recognizes no gain or loss on the distribution. c. The estate or trust may not elect to recognize gain or loss since 643(e) does not apply to distributions of cash. d. Cash has a basis equal to its denomination. e. The holding period is not an issue. The distribution of property in kind to fund a residuary bequest under 643(e) has the following tax consequences: a. The distributed property carries out DNI to the beneficiary but the amount of the DNI depends upon whether the estate or trust elects to recognize gain or loss under 643(e). 663(a)(1) doesnt apply to residuary bequests.52 b. The amount the distributee beneficiary must include in his gross income and that the estate or trust may deduct depends upon whether the estate or trust elects under 643(e) to recognize gain or loss.

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i. If the estate or trust does not elect to recognize gain or loss, the distribution carries out DNI equal to the lesser of the basis of the property or the propertys fair market value on the date of distribution.53 ii. If the estate or trust elects to recognize gain or loss, the distribution carries out DNI equal to the propertys fair market value.54 c. The estate or trust is not required to recognize gain or loss on the funding of a residuary bequest with appreciated property because a residuary bequest is not a bequest of a specific dollar amount or specific property.55 However, 643(e) permits the estate or trust to elect to recognize gain or loss when satisfying a residuary bequest with appreciated property.56 See, however, the discussion below, for the denial of loss recognition under 267 for distributions between related parties. d. The basis of the distributed property to the distributee beneficiary is equal to the basis of the property in the hands of the estate or trust plus or minus any gain or loss the estate or trust elects to recognize on the distribution.57 e. The holding period of the distributed asset should carry over to the distributee and, as such, the holding period should tack under 1223(2). Under 643(e)(1) the basis of the distributed asset appears to be determined with reference to the trust or estates basis. Under 1223(2), if the basis of the distributed asset is determined in whole or in part with reference to the assets basis in the hands of the transferor, the holding period of the transferor tacks to the holding period of the transferee. Thus, the basis of the distributed asset carries over to the distributee and, as such, results in the tacking of the holding period under 1223(2). If the assets was held at the date of death and included in the decedents gross estate for federal estate tax purposes, the holding period of the transferor will be an automatic long-term holding period under 1223(10). Example: A trust has DNI of $50,000. The trustee funds a residuary bequest by transferring stock with a fair market value of $50,000 and a basis of $20,000. The trustee makes a 643(e) election. The distribution of stock carries out $50,000 of DNI (the fair market value of the stock). The 643(e) election causes the trust to recognize gain of $30,000 ($50,000 FMV less $20,000 basis). The beneficiary takes a $50,000 basis in the distributed stock (the trusts $20,000 basis plus the $30,000 of gain recognized by the trust). Since the beneficiarys basis is determined in whole or in part by reference to the trusts basis in the stock, the trusts basis of the stock is tacked onto the beneficiarys holding period for purposes of determining if the gain is long-term or short-term. The 643(e) election gives the fiduciary the opportunity to shift tax consequences between the estate or trust and its beneficiaries. For example, it gives the fiduciary an opportunity to shift capital gains and losses to the beneficiaries in a year before termination. Generally, capital gains and losses are taxed to the estate or trust and get passed out to the beneficiaries only in the year the estate or trust terminates.58 If the fiduciary funds a residuary bequest using appreciated property and does not make the 643(e) election, the beneficiary takes the property with the same basis as it had in the trust or estates hands. The beneficiary can then sell the asset and realize the gain or loss on its own. This allows the beneficiary to time the recognition of gain and losses. The beneficiary may then recognize gains to offset its own losses or to recognize losses to offset

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its own gains. Alternatively, the gain will be eliminated if the property is held by the beneficiary until death and the asset receives a step-up in basis. Making the Election. A 643(e) election is made by the estate or trust on its return for the taxable year for which the distribution was made. The election is made by checking a box on the bottom of page 2 of the Form 1041. The election applies to all property distributions made during the year with the exception of 663(a) property distributions.59 Thus, the estate or trust may not make a 643(e) election in a particular year for some property distributions but not for others. Once made, the election may only be revoked with the consent of the Secretary of the Treasury.60 The election is made on a year-by-year basis i.e. it can be made for property distributions in one year but not the next. The revocation of the 643(e) election may be approved through a Reg. 301.9100 relief request.61 Planning with 643(e). 643(e) gives the fiduciary a number of planning options. Perhaps most important, it gives the fiduciary the option of choosing whether the fiduciary or the beneficiary will report the gains and losses on property which is distributed in-kind to the beneficiary. The fiduciary has the following options: i. Make the election to incur gains at the estate or trust level to offset the estate or trusts previously recognized losses. ii. Make the election in order to carry out the maximum amount of DNI to the beneficiary i.e. DNI equal to the fair market value of the distributed property. iii. Make the election to incur a loss at the estate or trust level in order to offset previously realized gains. iv. Dont make the election and distribute low basis/high fair market value property to a beneficiary, thus giving the beneficiary the opportunity to sell the property and realize the gain, either to offset a prior loss or to have the gain taxed at a lower rate than it would have been taxed in the estate or trust. Alternatively, the beneficiary could hold the property until his death and the step-up in basis allowed under 1014 will eliminate the gain. v. Dont make the election when distributing high basis/low fair market value assets enabling the beneficiary to realize a loss on a subsequent sale. vi. Make the election when funding a residuary or fractional bequest with an interest in a passive activity in order to trigger a deduction against nonpassive income for any unused suspended passive activity losses (PALs) applicable to the PALs transferred. The 643(e) election will also affect the amount and the character of the income taxable to the estate or trust and the beneficiaries. Example: Trust has DNI of $3,000 and the trustee distributes appreciated property to the beneficiary. The property has an adjusted basis of $1,000 and a fair market value of $2,500. If the 643(e) election is made, the beneficiary will have a basis of $2,500 in the property and will be required to report $2,500 of ordinary income pursuant to 662(a)(2). If no 643(e) election is made, the beneficiary will have a basis of $1,000 in the property

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and will be required to report $1,000 of ordinary income. Therefore, by not making the election, the beneficiary benefits by having $1,500 of ordinary income converted into potential capital gain i.e. the potential gain is shifted to the beneficiary. On the other hand, if the 643(e) election is not made, the trust suffers by converting $1,500 of capital gain into $1,500 of ordinary income. A fiduciary should be aware of the impact of the 643(e) election when there are multiple beneficiaries and the trustee distributes cash to some and property to others.62 Example: Trust has $3,000 of DNI. Assume the separate share rule does not apply. Trustee distributes $5,000 in cash to beneficiary A and distributes property with a basis of $2,500 and a fair market value of $5,000 to beneficiary B. If no 643(e) election is made, under 662(a)(2) beneficiary B is treated as receiving a distribution equal to the basis of the property ($2,500) and will be taxed on only $1,000 of income ($3,000 DNI x $2,500 distribution/$7,500 total distribution). Beneficiary A will recognize $2,000 of income ($3,000 DNI x $5,000 distribution/$7,500 total distribution). If the 643(e) election is made to recognize gain in the trust, both A and B are treated as receiving equal amounts under 662 and both will be required to report $1,500 of income ($3,000 DNI x $5,000 distribution/$10,000 total distribution). If a fiduciary makes a 643(e) election to recognize capital gain and the capital gain is included in DNI, any distribution to the beneficiary will cause the gain to be carried out and taxable to the beneficiary.63 Example: In the year of termination of a trust, the trustee distributes property with a fair market value of $35,000 and a basis of $20,000. The trustee makes a 643(e) election. The trust recognizes a capital gain of $15,000. The $15,000 becomes part of DNI in the year of termination. Assuming the distribution carries out all of the trusts DNI, the beneficiary is taxed on the gain. Another word of caution for the fiduciary. 1239 will convert any gain recognized by the trustee as a result of the 643(e) election to ordinary income if the appreciated property distributed by the fiduciary to the beneficiary may be depreciated by the beneficiary.64 For tax years beginning after August 5, 1997, the same rule applies to estates except in the case of appreciated property used to satisfy a pecuniary bequest.65 If an executor or trustee distributes property that has a basis in excess of its fair market value (i.e. loss property), the distribution will carry out DNI equal to the fair market value of the property whether or not the trustee makes the 643(e) election.66 The reason for this is that whether or not the 643(e) election is made, gain or loss is recognized as if the property were sold to the beneficiary at its fair market value. If the distribution is made to a related taxpayer, 267 will disallow the loss. In either event, the amount taken into account 661(a)(2) and 662(a)(2) will be the fair market value of the property and the basis of the property in the hands of the beneficiary will be the same as the trusts basis in the property immediately before the distribution. Stated differently, if property has declined in value, the amount taken into account under 661(a)(2) and 662(a)(2) and the propertys basis will be the propertys fair market value, whether or not an election is made. Example: Trustee funds a residuary bequest by transferring stock with a fair market value of $30,000 and a basis of $50,000. The trustee does not make a 643(e) election. The amount taken

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into account under 661(a)(1) and 662(a)(2) is the fair market value of the stock (lower of FMV and trusts basis) and the trusts basis in the stock carries over to the beneficiary (no gain or loss is recognized so trusts basis carries over to beneficiary). If the trustee made a 643(e) election, 267 would disallow recognition of the loss. The amount taken into account under 661(a)(1) and 662(a)(2) is the fair market value of the stock (FMV pursuant to 643(e)(3)(A)(iii)) and the trusts basis in the stock carries over to the beneficiary (no gain or loss is recognized so trusts basis carries over to beneficiary pursuant to 643(e)(1)). Thus, where a fiduciary distributes property that has a basis in excess of its fair market value, the tax results are the same whether or not the trustee makes the 643(e) election. VI. NONRECOGNITION OF LOSS - 267 In the context of funding bequests, 267 can result in the denial of loss recognition if (1) the fiduciary funds a pecuniary bequest with an asset with a basis in excess of its fair market value or (2) the fiduciary incurs a loss as the result of making a 643(e) election. However, the recognition of the loss is not permanent. The related party rules of 267 prohibit the recognition of losses that arise from transactions between related parties. The term related party is defined in 267(b) to include: (1) a fiduciary of a trust and a fiduciary of another trust, if the same person is the grantor of both trusts - 267(b)(5); (2) a fiduciary of a trust and a beneficiary of the same trust - 267(b)(6); (3) a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts - 267(b)(7); and (4) for taxable years beginning after August 5, 1997, an estate and a beneficiary of that estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest 267(b)(13). Thus, a loss incurred by an estate in funding a pecuniary bequest is recognized. If the trusts loss is disallowed by 267, it is not lost forever, Instead, on the beneficiarys subsequent sale or exchange of the distributed property gain is not recognized to the extent of the previously disallowed loss.67 Example: Trust distributes property having a fair market value of $20,000 and a basis of $26,000 to a marital trust to fund a pecuniary formula bequest. Although the funding of a pecuniary bequest with appreciated or depreciated assets is normally a recognition event, the loss on the distribution is disallowed by 267 because the funding trust and the marital trust are related parties under 267(b)(5). If the marital trust later sells the property for more than $20,000, up to $6,000 of the gain is not included in gross income. However, if the marital trust sells the property for $20,000 or less, the basis for computing loss is only $20,000.68 As noted above, the 1997 legislation added an estate and its beneficiaries to the list of related parties for taxable years after August 5, 1997. However, that rule is subject to an exception. If an estate funds a pecuniary bequest with assets whose basis exceeds their fair market value, the estate may recognize the loss.69 If, on the other hand, the funding were between a trust and its beneficiary, 267 would disallow the loss. Thus, funding a pecuniary bequest with loss assets

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results in an estate, but not a trust, being able to recognize the loss. The trustee of an eligible trust who would like to recognize the loss on funding could make a 645 election to be treated as an estate. The trust would then be eligible to deduct the loss on funding. Instead of using assets with a built-in loss to fund a pecuniary bequest, the trustee should consider selling the asset and recognize the loss at the trust level. The trustee can then use the loss at the trust level and distribute the cash proceeds to the beneficiary to fund the bequest. Alternatively, the trustee could make an in-kind distribution and not make the 643(e) election. In that case, the timing and recognition of the loss is up to the beneficiary. VIII. FUNDING A BEQUEST WITH INCOME IN RESPECT OF A DECEDENT (IRD)

A.

Allocation of IRD and the 691(c) Deduction When IRD is Payable to an Estate or Trust

If an item of IRD is payable to an estate or trust and is not distributed in the year of receipt, the IRD will be taxed to the estate or trust and the 691(c) deduction will be deductible by the estate or trust. In other words, if the IRD is allocated to principal of the estate or trust and is distributed to a beneficiary in a subsequent year, the 691(c) deduction is allocable only to the estate or trust.70 If an item of IRD is payable to an estate or trust and is distributed in its entirety to an estate or trust beneficiary in the year of its receipt, the IRD enters into the calculation of distributable net income (DNI) (unless it is capital gain income) and is passed out to the beneficiary. In addition, the 691(c) is also passed out to the beneficiary.71 If an item of IRD is payable to an estate or trust and is partially distributed to an estate or trust beneficiary, the IRD enters into the calculation of DNI (unless it is capital gain income) and a portion of the IRD and the 691(c) deduction will be passed out to the beneficiary based on the distribution rules of 651, 652, 661 and 662.72 Example: The executor of an estate receives taxable interest of $5,500 and IRD of $4,500 during the taxable year. The 691(c) deduction is $1,500. The executor makes a discretionary distribution of $2,000 to the sole beneficiary during the year. The DNI of the estate is $10,000 consisting of taxable interest of $5,500 and IRD of $4,500. The amount of the distribution deduction allowed to the estate under 661(a) and the amount taxable to the beneficiary under 662(a) is $2,000 as DNI exceeds the amount of the distribution. The balance of the DNI of $8,000 is taxable to the estate. IRD makes up 45% of the DNI ($4,500/$10,000). Thus, of the $2,000 distributed to the beneficiary, $900 (45% x $2,000) is IRD and the $1,100 balance is taxable interest. In addition, $300 ($900/$4,500 x $1,500) of the 691(c) deduction is allocated to and may be deduced by the beneficiary and the $1,200 balance of the 691(c) attributable to the estate ($3,600/$4,500 x $1,500) is allocated to and may be deducted by the estate. The estates taxable income of $6,200 is calculated as follows: $10,000 gross income less $2,000 distribution deduction less $1,200 691(c) deduction less $600 exemption. Notice that the executor can control who gets taxed on the IRD. If the executor retains the IRD, the estate pays the tax on the IRD and gets the 691(c) deduction. On the other hand, if the executor distributes the IRD to a beneficiary who then collects the IRD, the beneficiary pays the tax on the IRD.

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As discussed below, the distribution of the right to IRD (as opposed to the actual receipt of IRD) is not a distribution for purposes of Subpart C of Part 1 of Subchapter J. This means that an estate or trust that distributes the right to IRD is not entitled to an income tax distribution deduction and the amount is not included in the income of the recipient beneficiary. In other words, the distribution rules of 651, 652, 661 and 662 do not apply to the right to IRD.73 For example, the distribution of an installment note to a beneficiary of the estate is not subject to the distribution rules. Instead, the beneficiary reports the deferred gain upon receipt. B. Transfer of Right to IRD - 691(a)(2).

To prevent a high-bracket taxpayer from transferring IRD to a low-bracket taxpayer, 691(a)(2) treats the disposition of an item of IRD from the person who received or had the right to receive an item of IRD as a taxable transaction to the transferor as if the IRD had been collected. The term transfer includes a sale, exchange or other disposition, or the satisfaction of an installment obligation at other than face value. Under this definition, even a gift of the right to receive IRD will accelerate the recognition of the income.74 The general rule is that IRD is taxable to the recipient in the taxable year when received. 691(a)(2) is an exception to the general rule. It says that where the holder of a right to receive an item of IRD transfers it to another, nonexempt person, the transferor must include in gross income for the year of transfer the greater of: a. The fair market value of the rights transferred or b. The consideration received in exchanged therefore. Example: Widow has the right to receive a $5,000 salary claim that was owed to her cash basis husband at the date of his death. Widow sells the salary claim for $4,000 (it had a FMV of $5,000). The widow would include $5,000 in her income. This acceleration rule applies both to sales of IRD rights to non-beneficiaries and to transfers of IRD rights to beneficiaries who are not entitled to receive them under the terms of the governing will or trust instrument.75 The transfer to a person entitled to receive the IRD by reason of the death of the decedent or by bequest, devise or inheritance from the decedent is not a transfer that causes acceleration of the taxation of the IRD. Notice that those exempt from the transfer rule are those who would otherwise be responsible for reporting IRD under of 691(a)(1). Thus, the term "transfer" as used in 691(a)(2) does not include these 3 situations i.e. there are 3 exceptions to the rule of 691(a)(2): c. Estate transfers the right to receive IRD to a beneficiary of the estate e.g. a specific or residuary legatee. d. Trust is bequeathed IRD and trust terminates and distributes IRD to beneficiary. e. Income in respect of a prior decedent.76

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Example: Decedent dies with a $5,000 salary owed to him at the time of his death and so now it is owed to his estate. His estate terminates and transfers his salary to the Decedent's widow. This is the first exception to 691(a)(2) so it is not a "transfer." The widow dies before she gets the $5,000 IRD. The widow's son is the beneficiary of her estate and now the son gets the $5,000 salary claim transferred from his mother's estate to him. This is not a transfer. This is the 3rd exception i.e. income in respect of a prior decedent. The son reports the income when he actually receives it. In addition, the transfer of the IRD to the estate of the decedent is also an exempt transfer. Notice that the transfer exception applies to successive recipients of the item of IRD as long as all of the recipients qualify for the transfer exemption.77 Thus, an estate can transfer the item of IRD to a trust which can then transfer it to a beneficiary of trust who can transfer it to his own trust at his death and all of the transfers would be considered exempt transfers i.e. transfers that do not accelerate the taxation of the item of IRD. The item of IRD would be taxable when it is ultimately collected or when it is transferred in a taxable transfer i.e. to a nonexempt beneficiary. C. Coordination with the Separate Share Rule

If a single trust has more than one beneficiary and if different beneficiaries have substantially separate and independent shares, their shares are treated separately for the sole purpose of determining the amount of DNI allocable to the beneficiaries under 661 and 662.78 663(c) states that for the sole purpose of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Thus, the effect of the separate share rule is to treat multiple beneficiaries of a single trust or estate as if each were the sole beneficiary of a single trust for the purposes of determining how much DNI each distribution carries out. The separate share rule prevents one trust or estate beneficiary who receives a distribution from receiving more than his pro-rata share of DNI. Without the separate share rule, disproportionate distributions to beneficiaries from a trust or estate can lead to disproportionate tax treatment for the beneficiaries. If separate shares exist, DNI is computed separately for each share.79 Traditionally, the separate share rule applied only to trusts. Effective for decedents dying after August 5, 1997, the separate share rule now applies to estates as well. After the fiduciary has identified the separate shares, the fiduciary must allocate the items of income and deductions among those shares to compute the DNI for each share. In computing DNI for each separate share, the portion of gross income that is income under Section 643(b) must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable local law.80 An important exception to the allocation rules applies to income in respect of a decedent (IRD). The final regulations provide that IRD is allocated among the separate shares that could potentially be funded with these amounts irrespective of whether the share is entitled to receive any income under the terms of the governing instrument or applicable local law. The amount of gross income allocated to each share is based on the relative value of each share that could potentially be funded with such amounts.81

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This potential allocation of IRD could shift income tax liabilities to trusts that are protected from estate tax or GST tax by the decedents exemptions. Practitioners may want to draft to limit or eliminate the potential recipients of IRD. Although the final regulations do not address the issue directly, expenses that are directly attributable to items of IRD presumably should be allocated in the same manner as the IRD itself i.e. those expenses would be allocated among the separate shares that could potentially be funded with the IRD in proportion to the relative values of those shares. Example: Ds will directs the executor to divide the residue of the estate equally between Ds two children, A and B. The will directs the executor to fund As share first with the proceeds of Ds IRA. The FMV of the estate is $9,000,000. During the year, the $900,000 balance in Ds IRA is distributed to the estate that is allocable to corpus under local law. The estate has 2 separate shares: one for A and one for B. If any distributions are made to either A or B during the year, then for purposes of determining the DNI for each separate share, the $900,000 of IRD must be allocated to As share. If the will did not direct the executor to fund As share with the IRA proceeds (and assuming state law was silent on the allocation issue), a distribution to either A or B would carry our IRD to either share regardless of which share actually received the IRD. Thus, specific direction in the governing instrument about allocating IRD will be recognized as overriding the regulations requirement of allocating IRD among all the potential recipients.82 Thus, if the separate share rule applies to a beneficiary and the trust instrument does not otherwise specify the allocation of the IRD, a fiduciary is no longer able to control the recipient of IRD by making disproportionate distributions during the year the trust or estate recognizes IRD. However, it is still possible to control the recipient of IRD if the right to IRD (as opposed to the IRD itself) is distributed. In other words, if an executor or trustee assigns IRD to a share, the entire IRD will be recognized by that particular share as the IRD is collected.83 This assumes, of course, that the transfer of the right to the IRD does not accelerate the recognition of the IRD to the transferor under 691(a)(2). The final separate share regulations require the practitioner pay careful attention to the income tax aspects of IRD. The issues that can arise are illustrated by Examples 9 and 10 of Reg. 1.663(c)-5. As illustrated above, Example 9 indicates that a specific direction in the governing instrument allocating IRD will be recognized as overriding the regulations requirement of allocation among potential recipients. In Example 9 the estate received a distribution from an IRA. The will provided for distribution of the residue in equal shares to the decedents two children. The will also directed that one childs share be funded first with the IRA proceeds. The results in Example 9 confirm that the IRA income will be allocated to that childs share, instead of being allocated equally to each child as would have been required absent the direction in the will to allocate the IRD to one particular child. Often practitioners intentionally fund gifts or bequests of IRD to the surviving spouse, especially if this can be done without triggering an income tax. This is usually accomplished by making a specific bequest of the IRD to the spouse. Leaving IRD to a surviving spouse allows the estate of the surviving spouse to be reduced by the income tax that will have to be paid on the IRD thereby decreasing the potential future estate tax on the spouses death. This also avoids wasting the decedents unified credit or GST exemption on amounts that will be paid to the government as income tax. Thus, a specific bequest of IRD or a specific direction

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about using IRD in funding is now necessary to avoid the final regulations requirement mandating a proportionate allocation of IRD among all potential recipients. This is especially important in the case of an estate or trust that would like to transfer IRD to a charity and qualify for the fiduciary income tax charitable deduction under 642(c). Distributions from an estate or trust to charity do not qualify for the income distribution deduction under 661. The only way to obtain a fiduciary income tax charitable deduction is under 642(c).84 Example: Decedent dies leaving $1,000,000 in stock and a $1,000,000 IRA to his trust. The trust terminates at Decedents death leaving 50% of his estate to charity and 50% to his son. The trust receives the proceeds of the IRA in 2005 (causing the full $1,000,000 to be included in the trusts taxable income for 2005) and transfers $1,000,000 to charity. The estate wants the $1,000,000 transferred to the charity to qualify for the fiduciary income tax charitable deduction under 642(c). The trust instrument does not direct which share gets the IRA. Thus, each share could potentially be funded with the IRA proceeds. Assuming the final separate share rule regulations apply for purposes of calculating the 642(c) deduction, only $500,000 of the amount would qualify for the 642(c) deduction as that is all that is deemed paid to charity. On the other hand, if the trust directed that the trustee fund the charitys share with the IRA proceeds (e.g. a specific allocation of IRD), the full $1,000,000 distribution would qualify for the 642(c) deduction. Alternatively, if the trustee did not cash out the IRA and receive the IRA proceeds in the trust, he could have assigned the right to receive the IRA proceeds to the charity assuming the trustee had the right to do so under the governing instrument or state law. In that case, the proceeds of the IRA would be distributed directly from the IRA to the charity where they would avoid income taxation due to the charitys exemption from income tax.85 Note that since the bequest to charity is specified in the trust instrument and is in the form of a fraction, the transfer of the IRD from the trust to the charity is not considered a transfer that would accelerate the recognition of the IRA income at the trust level under 691(a)(2). If the intent is to qualify for the fiduciary income tax charitable deduction under 642(c), the trust document should specify that IRD be used to fund any charitable bequest. Alternatively, the trustee may want to assign IRD to the charity. D. Funding a Pecuniary Bequest with IRD

If an estate or trust funds a pecuniary bequest with the right to IRD, the traditional view is that the funding accelerates the recognition of the IRD at the estate or trust level. This conclusion is reached in one of two ways: (1) under Reg. 1.661(a)-2(f) (which provides that an estate or trust must recognize taxable income upon funding a specific dollar amount (e.g. a specific bequest) with appreciated property) or under 691(a)(2) (which, subject to certain exceptions, taxes the transfer of IRD).86 This issue usually arises when the decedent names his living trust as the beneficiary of IRD and the trust splits into a pecuniary marital and a credit shelter trust after the decedents death. If the trustee uses right to receive IRD to fund the pecuniary marital, the recognition of income issue arises. This same issue would arise if the trust provides for a pecuniary bequest to charity (and the trust does not require charitable bequests to be satisfied with IRD) and the trustee uses the right to IRD to fund the pecuniary charitable gift. It appears that those who rely on Kenan and Reg. 1.661(a)-2(f) assume that funding a pecuniary bequest with IRD will be treated the same as a bequest funded with non-IRD assets (i.e. gain will be required to be recognized). However, there doesnt appear to be statutory authority for this

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result. In fact, according to one case the taxation of the right to income in respect of a decedent appears to be governed exclusively by 691.87 If IRD is governed exclusively by 691, it appears that only 691(a)(2) would govern the recognition of any gain and 691(a)(2) specifically exempts receipt of amounts by bequest, devise or inheritance from its provisions. 691(a)(2) taxes the transfer of IRD. A transfer under 691(a)(2) is defined as a sale, exchange or other disposition. However, 691(a)(2) says that a transfer of IRD made to a person pursuant to the right of such person to receive such amount by bequest, devise or inheritance is not a taxable transfer under 691(a)(2). It is questionable whether the funding of a pecuniary bequest with IRD would result in the recognition of income under 691(a)(2) as it would seen that the marital trust is receiving the amount by bequest, devise or inheritance thereby satisfying an exception under 691(a)(2). However, until the issue is finally settled, it is better to take a safe approach and avoid the issue altogether. The acceleration of income problem for an estate or trust can be avoided if the bequest of the IRD is a specific bequest. Reason: a specific bequest of the IRD does not result in the acceleration of the IRD.88 Alternatively, structuring the bequest as a fractional or residuary bequest will avoid the recognition issue. Generally, the distribution of a right to receive IRD (as opposed to distributing the IRD that has been collected) will not accelerate the recognition of the IRD by the distributing trust or estate if (1) the items of IRD is specifically bequeathed and the fiduciary distributes the claim to the legatee or (2) if the IRD is part of the residue of the trust or estate and the fiduciary distributes the claim to the residuary legatee.89 Thus, the fiduciary can fund a specific bequest, fractional bequest or residuary bequest with the right to receive future payments of IRD without triggering income to the distributing estate or trust.90 To prevent the funding of a pecuniary bequest with income in respect of a decedent from resulting in the recognition of income, consider including language in the governing instrument that provides that to the extent possible, pecuniary gifts shall be satisfied by distribution of property constituting income in respect of a decedent. This establishes the decedents intent to make a specific bequest of the IRD rather than have it treated as a pecuniary bequest funded with income in respect of a decedent. Alternatively, the executor or trustee could assign the right to IRD to the pecuniary beneficiary without the recognition of income.91 E. Funding a Bequest with Installment Obligations

General Rule. Generally, when a seller dies before collecting all payments due under an installment sale contract, the unreported gain of the installment obligation is IRD.92 Ordinarily, when installment obligations are transferred, the untaxed installment gain is taxed all at once in the year that the installment obligations are transferred. This is the normal rule under 453.

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Transfer of Decedents Installment Obligation. 453B(c) says that the general rule concerning recognition of gain or loss on the transfer of installment obligations at death is inapplicable and 691 controls the taxation of the installment obligation.93 Thus, the installment obligation owned by a decedent becomes an item of IRD. That means that if an installment obligation passes from a decedent to his estate, the estate and its beneficiaries report the gain from the installment note as it is received just as the decedent would have reported it if he lived. The transmission of installment obligations at death is not a disposition that triggers recognition of gain if such obligation is acquired by the decedents estate from the decedent or by any person by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent.94 Thus, where the transfer of the decedents installment obligation is made to the estate or a specific or residuary beneficiary of the person to whom the installment obligations are owed and the transfer occurs by reason of that person's death or by bequest, devise or inheritance from the decedent, the transfer will not trigger the immediate taxation of all the untaxed installment gain. Instead Reg. 1.691(a)-5 says the estate or the beneficiaries shall continue to report as income (when collected) the same pro-rata part of each installment payment as the decedent would have reported had he lived to receive it. Essentially, installment sale treatment is preserved in this situation. The recipient of the installment payments use the same gross profit ratio used by the decedent to determine the portion of each payment that represents IRD. Installment Obligations Created by the Fiduciary. If the fiduciary distributes to a beneficiary an installment obligation received as a result of a sale made by the fiduciary, 453B(a) requires the recognition of gain. The exception outlined above applies only to installment notes made by the decedent, not to installment notes made by the decedents representative. The gain recognized on a distribution of an installment obligation in this case is the excess of the value of the installment obligation at the time of distribution over the basis of the installment note. The beneficiarys basis in the distributed installment obligation is the sum of the estate (or trusts) basis and the gain recognized by the estate (or trust).95 Thus, the beneficiarys basis in the installment note equals the fair market value of the note as of the date of distribution. Unless the installment note is deeply discounted from its face value, the beneficiary will recognize little or no gain as the subsequent installment payments are collected. The estate (or trust) will be entitled to take an income distribution deduction for the fair market value of the note.96 Taxable Transfers. If the installment obligation is transferred by gift, sale, exchange, or other disposition, the transferor must recognize the income that would otherwise be deferred i.e. the income recognition is accelerated.97 The amount included in the transferors gross income is the fair market value of the obligation at the time of the transfer or the consideration received for the transfer of the installment obligation, whichever is greater, reduced by the basis of the obligation at the time of the transfer.98 Thus, if the consideration received exceeds the obligations fair market value, the excess must be included in the transferors gross income. Conversely, if the obligation is disposed of for less than its fair market value, the higher fair market value (rather than the amount received) is used in computing gross income. A transfer of an installment obligation to the obligor will not qualify for the exception the transfer will result in recognition of the IRD even if the obligor is a person who would otherwise qualify for an exception i.e. a beneficiary of the decedents estate.99

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If the decedent and the obligor are related parties (as defined in of 318(a)(disregarding 318(a)(4)) or 267(b), the fair market value of the obligation cannot be less than the face amount of the note.100 The cancellation of an installment obligation is treated as a transfer to the obligor that accelerates the recognition of the gain on the installment note.101 If the cancellation occurs at the decedents death (e.g. a SCIN), the cancellation is treated as a transfer by the estate (or other holder of the note) that results in the acceleration of the gain on the note and the recognition of the income by the estate.102 Cancellation is defined to include anything that causes the obligation to become unenforceable.103 An installment note that becomes unenforceable under state law is treated as if it were canceled.104 Thus, the expiration of the statute of limitations on the enforceability of the note is treated as a cancellation. Unintended consequences. If the decedents installment obligation is forgiven or cancelled, the decedents estate will bear the burden of the income tax when the maker of the note is not a beneficiary of the estate. For example, the decedent, under his will, forgives a note given to him by A, and B is the sole beneficiary of the decedents estate. The decedents estate is deemed to have made a transfer of the note that causes acceleration of the taxation of the note. The estate will be taxed on the value of the note. The tax will be borne by B as the sole beneficiary of the estate, even though A is relieved of the payment obligation.

VII. CONCLUSION The rules governing the income tax consequences of funding bequests are complicated. However, analyzing the components of the distribution makes the task easier. First, identify the type of bequest. Second, answer the six income tax issues for that type of distribution. The rules stated above can be easily applied once the type of bequest is identified. In many cases, a detailed examination of the governing instrument (the will or trust) is necessary in order to determine the correct income tax characterization.
Reg. 1.663(c)-1(a). Reg. 1.663(c)-2(b)(1). 3 Reg. 1.663(c)-2(b)(2). 4 For example, the separate share rule has special application to the funding of a pecuniary formula bequest. Under the final separate share regulations, a pecuniary formula bequest that is entitled to income and to share in appreciation and depreciation under the governing document or local law constitutes a separate share. In addition, the regulations also state that a pecuniary formula bequest that is not entitled to income or to share in appreciation or depreciation is also a separate share if the governing document does not provide that it is to be paid in more than three installments. Reg. 1.663(c)-4(b). For an example of the application of this rule assume a funding trust provides for a distribution of a pecuniary formula amount to a marital trust and the balance to a family trust. The trust provides that marital trust is not entitled to any of the funding trusts income and does not share in appreciation or depreciation of the funding trusts assets. The marital trust is a separate share. Assume the funding trust receives dividend income of $50,000. The trustee partially funds the marital trust by distributing $100,000 of assets with a $20,000 basis. The funding of a pecuniary marital with appreciated assets results in the funding trust recognizing an $80,000 gain ($100,000 FMV less $20,000 basis). Normally, the distribution of property to fund the pecuniary marital would carry out DNI to the marital trust equal to the propertys fair market value, limited by DNI. However, the funding trust has two separate shares the marital share and the family share. Since the marital share is not entitled to income or to share in the appreciation or depreciation of the funding trusts
2
1

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assets, the DNI for the marital share is zero. Thus, even though the trustee of the funding trust distributed $100,000 to the pecuniary marital, the distribution does not carry out DNI to the marital trust because, under the separate share rule, none of the funding trusts $50,000 of dividend income is allocable to the marital trust. 5 Reg. 1.663(a)-1(b)(1). 6 Reg. 1.663(a)-1(b)(1). 7 Reg. 1.663(a)-1(b)(1). 8 Rev. Rul. 60-87, 1960-1 C.B. 286; Reg. 1.663(a)-1(b)(1). 9 Reg. 1.663(a)-1(b)(1). 10 The number of installments required by the trust or will govern even if the trustee or executor makes the payments in more than three installments. Reg. 1.663(a)-1(c)(2), Example 1. Reg. 1.663(a)-1(c)(1) contains a further explanation and examples of the application of the three installment rule. 11 663(a)(1), last sentence. 12 Reg. 1.663(a)-(1)(a). 13 Reg. 1.663(a)-(1)(a). 14 Reg. 1.661(a)-2(f); GCM 34,666. 15 643(e)(4). 16 Reg. 1.1014-4(a). 17 1223(10). 18 Reg. 1.663(a)-(1)(a). 19 Reg. 1.661(a)-2(f); Rev. Rul. 86-105, 1986-2 C.B. 82; Rev. Rul. 82-4, 1982-1 C.B. 99; Rev. Rul. 66207, 1966-2 C.B. 243. 20 Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940); Suisman v. Eaton, 15 F. Supp. 113 (D. Conn, 1935), affd per curiam, 83 F.2d 1019 (2d Cir. 1936); Freeland, Maxfield and Sawyer, Estate and Trust Distributions of Property In Kind After the Tax Reform Act of 1984, 40 Tax Law Review 449, 470 (Winter, 1985). 21 Reg. 1.661(a)-2(f). 22 Reg. 1.1014-4(a)(3). 23 Reg. 1.1014-4(a)(3). 24 Citizens National Bank of Waco v. United States, 417 F.2d 675 (5th Cir. 1969). 25 663(a)(1). Reg. 1.663(a)-1(a). 26 Reg. 1.663(a)-1(c)(1)(iii). 27 If a bequest of a specific sum of money is made and, as of the date of distribution, there is not enough in the trust or estate to satisfy the bequest, the rules of 663(a)(1) still apply. Even though the value of the assets remaining in the estate is less than the value of the bequest of the specific sum of money, the bequest is not deemed to be a residuary bequest which would no longer be governed by 663(a)(1). However, if the bequest is satisfied with appreciated assets, the trust or estate will be required to recognize gain. Example: Decedents will leaves $300,000 to his uncle, Wigley. After the payment of all the estates debts and administration expenses, all that remains in the estate is an asset worth $200,000 with a basis of $125,000. The executor transfers the asset to Uncle Wigley in satisfaction of the specific bequest. 663(a)(1) still applies so that the estate does not receive an income distribution deduction and Uncle Wigley is not required to include the value of the asset distributed in his income. However, the use of an appreciated asset to satisfy the specific bequest of $300,000 results in the recognition of a $75,000 ($200,000 - $125,000) by the estate. PLR 9548020; Rev. Rul. 66-207, 1966-2 C.B. 243. 28 Reg. 1.663(a)-1(b). 29 Reg. 1.663(a)-1(a). 30 Reg 1.661(a)-2(f). Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940); Suisman v. Eaton, 15 F Supp.113 (D.Conn 1935) affd per curiam, 83 F2d 1019 (2d Cir. 1936). 31 Reg. 1.661(a)-2(f); Reg. 1.1014-4(a)(3). 32 Reg. 1.1014-4(a)(3). 33 Rev. Rul. 73-322, 1973-2 C.B. 44. 34 Reg. 1.663(c)-5, Example 7; Schwan v. United States, (D.S.D., No. 01-4171, March 16, 2003). 35 Reg. 1.663(a)-1(b)(1).

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Reg. 1.663(a)-1(b)(1). See also PLR 200210002 where a bequest was deemed not to be a bequest of a specific sum of money where the bequest was not ascertainable as of the date of death since the amount of the bequest was dependent upon the amount of the decedents unified credit, state estate taxes, administration expenses and the amount of an elective share. 37 Id. 38 See Reg. 1.1014-4(a)(3); Rev. Rul. 60-87, 1960-1 C.B. 286; Reg. 1.663(a)-1(b)(1). 39 A fiduciary will recognize gain where a beneficiary is entitled to receive a pecuniary amount and receives appreciated property instead. Gain must be recognized where a beneficiary is entitled to receive a distribution of cash or income but receives a distribution of appreciated property or receives appreciated property in lieu of specifically devised property. Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940) (transfer of appreciated securities in satisfaction of a portion of a $5 million bequest); Suisman v. Eaton, 15 F Supp.113 (D.Conn 1935) affd per curiam, 83 F2d 1019 (2d Cir. 1936) (transfer of appreciated stock in satisfaction of $50,000 bequest); Reg. 1.661(a)-2(f); Reg. 1.1041-4((a)(3); Rev. Rul. 67-74, 1967-1 C.B. 194 (gain recognized on distribution in-kind to satisfy a beneficiarys right to receive income in cash); Rev. Rul. 83-75, 1983-1 C.B. 114 (gain recognized on distribution in-kind to satisfy a charitable beneficiarys right to receive an annuity payable by a charitable lead trust); Rev. Rul. 66-207, 1966-2 C.B. 243 (gain recognized on distribution in-kind to satisfy a beneficiarys right to receive pecuniary legacy or cash gain recognized even though estates assets were less then the stated legacy and beneficiary received all of the estates assets i.e. the residue); Rev. Rul. 60-87, 1960-1 C.B. 286 (gain recognized on distribution in-kind to satisfy a marital deduction pecuniary formula bequest); Rev. Rul. 82-4, 1982-1 C.B. 99 (gain recognized on transfer in-kind where equalization clause required executor to distribute from residue a specific sum of money to equalize a gift made to another beneficiary the equalization gift, funded in-kind, was considered a pecuniary legacy which triggered recognition of gain). See also PLR 8104015. 40 Reg. 1.661(a)-2(f); Reg. 1.1014-4(a)(3). 41 Reg. 1.1014-4(a)(3). 42 Reg. 1.663(a)-1(b)(2)(iii) 43 Rev. Rul. 69-486, 1969-2 C.B. 159 distinguished by Rev. Rul. 83-61, 1983-1 C.B. 78. These Revenue Rulings are cited in PLRs 199933027, 199930011, 199929021 and 199912034 for the proposition that non-pro-rata distributions are not taxable under 1001 or 691(a)(2) if the instrument or state law allows the fiduciary to pick and choose property or cash in satisfaction of a gift or bequest. Under a pecuniary formula clause the beneficiary receives assets having a value at the distribution date equal to the pecuniary amount. Under a fractional formula clause the beneficiary receives a percentage or fraction of the residue existing at the time of distribution. A fractional formula clause allows the beneficiary to share in the appreciation and depreciation of the value of the estate or trust. A beneficiary of a pecuniary amount gets only the pecuniary amount he does not share in any appreciation or depreciation of the assets. 44 One such item of complexity involves the application of the separate share rule to residuary bequests. Generally speaking, the income distribution deduction allowed an estate or trust and the amount of the distribution included in the beneficiarys income are limited by the estate or trusts DNI for the year of distribution. The purpose of the separate share rule is to allocate DNI among shares of the trust or estate that, according to the separate share regulations under 663(c), constitute separate and independent shares. On December 28, 1999 the IRS issued final separate share regulations under 663. The final regulations define the term separate share and expand the number of situations in which the separate share rule may apply. The final regulations clarify the application of the separate share rule to the funding of pecuniary bequests. Reg. 1.663(c)-5, Examples 4 and 5 provide an illustration of how the separate share rule applies to the funding of a pecuniary bequest. In instances where the funding of a bequest carries out DNI, the separate share rule regulations will determine whether the separate rule applies to the distribution and, if it does, the amount of DNI that will be allocable to each share. For a discussion of the complexities that the funding of a pecuniary bequest subject to the separate share rule can create for the fiduciary, see Randall, Gardner and Stewart, Distributions of Property From Estates and Trusts: Avoiding Income Tax Traps, Estate Planning, Vol 27/No.7, August/September, 2000. 45 Reg. 1.661(a)-2(f) 46 Although 643(e)(3) allows a fiduciary to recognize a loss on the in-kind distribution, the loss will be disallowed under 267 except in the case of an estate funding a pecuniary bequest.

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47

The Senate Report states: The bill does not change existing law in those cases where a distribution of property to a beneficiary results in recognition of gain or loss to the trust (or estate). S. Rep. No. 169, 98th Cong., 2d Sess., 246 (1984). The Conference Committee report states: This provision does not affect the uniform basis rules of the Code (such as the rule providing a basis adjustment for property received in satisfaction of a pecuniary bequest). H.R. Rep. No. 861, 98th Cong., 2d Sess., at 870 (1984). 48 643(e)(3). 49 643(e)(2) and (3). 50 643(e)(1). 51 Reg. 1.663(a)-1(b)(2)(iii). 52 Reg. 1.663(a)(1)-(b)(2)(iii). 53 643(e)(2). Accordingly, the amount treated as a distribution deduction under 661(a)(2) and included in the beneficiarys income under 662(a)(2) is the lower of the basis or fair market value of the distributed property. 54 643(e)(3). Accordingly, the amount treated as a distribution deduction under 661(a)(2) and included in the beneficiarys income under 662(a)(2) is fair market value of the distributed property. 55 Reg. 1.661(a)-2(f); Reg. 1.663(a)-1(b)(2)(iii); PLRs 8104015, 8447003; Rev, Rul. 60-87, 1960-1 C.B. 286. 56 643(e)(3). 57 643(e)(1). 58 Reg. 1.643(a)-3(a). 59 643(e)(3)(B), (e)(4). 60 643(e)(3)(B), last sentence.
61 See Private Letter Ruling 9641018 where a bank trustee was allowed to revoke a 643(e) election based on erroneous advice.

These concerns are eliminated if the separate share rule applies to the distributions. Under 643(a)(3) capital gains are included in DNI if they are allocated to income or allocated to principal and actually paid, credited or required to be distributed. In general, Reg. 1.643(a)-3 includes gains in DNI when they (1) are allocated to income under the terms of the governing instrument or state law, (2) allocated to corpus but treated consistently by the fiduciary as distributed to the beneficiry or (3) allocated to corpus but actually distributed to the beneficiary. Capital gains paid or used for a charity or permanently set aside for charity are also included in DNI. The regulations under 643 contain fourteen examples illustrating the inclusion of capital gains in DNI. Inclusion of capital gains in DNI will affect the character (ordinary income versus capital gain) of the distributions in the hands of the beneficiaries. It will also shift the party responsible for paying the tax on the capital gains. Gains incurred as a result of funding a pecuniary amount with appreciated property should not be included in DNI unless the gain is either allocated to income, the fiduciary distributes the gain to the beneficiary or the gain is incurred in the year the trust terminates. The same result should occur if the fiduciary elects under 643(e) to recognize gain. For a further discussion of the tax consequences of including gains in DNI, see Randall, Gardner and Stewart, Distributions of Property From Estates and Trusts: Avoiding Income Tax Traps, Estate Planning, Vol 27/No.7, August/September, 2000. 64 If 1239 causes gains recognized as a result of a 643(e) election to become ordinary income, this may cause the ordinary income generated by the election to become part of DNI. Generally, gains do not enter into the calculation of DNI. Inclusion of the deemed gain in DNI due to the operation of 1239 will generally result in a higher tax due to the change in character from capital gain to ordinary income. In addition, potentially more DNI will be carried out to the beneficiary due to the increase in DNI and the use of the fair market value of the asset to determine the amount of DNI carried out to the beneficiary. 65 1239(b)(3). 66 Prior to the Taxpayer Relief Act of 1997, there was a different result when an estate distributed property which has declined in value to a beneficiary. The amount taken into account by the beneficiary under 661(a)(2) and 662(a)(2) was the propertys fair market value whether or not the fiduciary elected to make the 643(e) election to recognize loss. The 643(e) election affected who recognized the loss, when such loss was recognized, and the basis of the property in the hands of the beneficiary. An estate was allowed to recognize a loss if a 643(e) election was made because an estate and beneficiary were not considered related parties under 267. If an election to recognize the loss was made, the estate recognized
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the loss in the year in which the property was distributed. If the election to recognize the loss was not made, the beneficiary will recognize the loss if and when he sells the property. Thus, an estate has an opportunity to shift the recognition of the loss from the estate to the beneficiary via the 643(e) election. 67 267(d). 68 Note the problem the property distributed to the marital trust has a different basis for computing gain and loss due to the deferral of the loss under 267. This presents a problem for the trustee of the marital trust pending the sale of the distributed assets. How should the trustee of the marital trust reflect the basis of the distributed property on its accounting system pending the sale of the distributed property. If trustee sells the distributed property at a gain, a portion of the gain equal to the loss not previously recognized is not recognized. On the other hand, if trustee sells the property at a loss, the beneficiarys basis is $20,000. In other words, the beneficiary will have one basis if the property is subsequently sold at a gain and a different basis if the property is subsequently sold at a loss. Most accounting systems will track only one basis. In these situations, the trustee should note that the basis will be different depending upon whether the asset is sold at a gain or loss. 69 267(b)(13). 70 Reg. 1.691(c)-2(a)(3). 71 Reg. 1.691(c)-2(a)(1). 72 691(c) (1)(B); Reg. 1.691(c)-2(a)(1). 73 Rollert Residuary Trust v. Commissioner, 80 T.C. 619 (1983) affd 752 F. 2d 1128 (6th Cir. 1985). 74 Reg. 1.691(a)-4(a). 75 Reg. 1.691(a)-4. 76 Reg. 1.691(a)-4(b). 77 Reg. 1.691(a)-4(b); Reg. 1.691(a)-1(c); Reg. 1.691(a)-2(b) Example 2. 78 Reg. 1.663(c)-1(a). 79 Reg. 1.663(c)-2(b)(1). 80 Reg. 1.663(c)-2(b)(2).
81 82
83

Reg. 1.663(c)-2(b)(3).

Reg. 1.663(c)-5, Example 9 and 10. See PLR 200234019 (authorizing the assignment of IRD to charity). 84 Reg. 1.663(a)-2; United States Trust Company v. United States 803 F.2d 1363 (5th Cir. 1986); Rebecca K. Crown Income Charitable Fund v. Comm. 98 T.C. 327 (1992); Estate of OConnor v. Comm 69 T.C. 165 (1977); Mott v. United States 462 F.2d 512 (Ct. Cl. 1972); Weir Foundation v. United States 508 F.2d. 894 (2d Cir. 1974); Pullen v. United States 80-1 USTC 9105 (D. Neb. 1979), affd 634 F.2d 632 (8th Cir. 1980); Rev. Rul. 68-667, 1968-2 C.B. 289. 85 PLR 200234019.
86

See GCM 39388 (May 25, 1984) (IRS concluded that a trust had to recognize gain when it distributed appreciated stock in satisfaction of a direction in the trust instrument to pay net income to the beneficiary); Rev. Rul. 83-75, 1983-1 C.B. 114 (in which the IRS concluded that a distribution of appreciated securities by a trust to a charity in lieu of current income resulted in taxable gain to the trust); Kenan v. Commissioner 114 F.2d 217 (2nd Cir. 1940).

87

Rollert Residuary Trust 752 F2d 1128 (6th Cir. 1985). See 691(a)(2); Reg. 1.691(a)-4(b). 89 Reg. 1.691(a)-4(b). Reg. 1.691(a)-2(b) Ex. 1 and 2.
88
90

Reg. 1.691(a)-4(b)(2); PLR 9537005.

91
92

PLR 200234019. 691(a)(4). 93 See 691(a)(4)(B). 94 691(a)(4). 95 643(e)(1). 96 643(e)(2). 97 691(a)(2). 98 Reg. 1.691(a)-5(b).

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691(a)(5)(A)(i). 691(a)(5)(B). 101 691(a)(5)(A)(ii); PLR 9108027. 102 Estate of Frane v. Comm., 998 F.2d 567 (8th Cir. 1993): Rev. Rul. 86-72, 1986-1 C.B. 253. 103 691(a)(5)(C). 104 691(a)(5)(C).
100

Naming a Trust as the Beneficiary of Retirement Plan Assets Administration Complexities After the Participants Death
Jeremiah W. Doyle IV, Esq. Senior Vice President - Mellon Financial Corporation Private Wealth Management Boston, MA May, 2006 I. Introduction. A. This outline deals with the practical post-death administration and income tax issues that will be encountered by a fiduciary in administering an estate or trust that is named as the beneficiary of retirement plan assets. B. Generally, the discussion below is relevant to both qualified retirement plans as well as IRAs. However, as a practical matter, the client's retirement plan assets will most likely be held in an IRA. The client's qualified plan will most likely be rolled over into an IRA by the time the estate plan takes effect. II. Overview of the issues. A. Overall, it is generally better to leave an IRA outright to an individual beneficiary (or beneficiaries) unless there is a separate, overriding reason for naming a trust as the beneficiary. 1. Reasons to leave retirement plan assets to trust: beneficiary is a minor, incompetent or a spendthrift, a second marriage is involved or it is otherwise unwise to leave it outright to an individual. In some cases, retirement plan assets may be left to a QTIP trust for estate planning purposes. B. Disadvantages of naming an estate or trust as the beneficiary of retirement plan assets: 1. Distributions may have to commence sooner after the retirement plan asset owners death than if payable to an individual beneficiary e.g. a spouse could rollover the distribution or treat the decedents IRA as her own deferring the minimum required distributions until he or she reaches his or her required beginning date. 2. Distributions may be greater during trust beneficiarys life. Generally, if the trust qualifies as a designated beneficiary the retirement plan assets payable to a trust must be distributed, in the best case, over the single life expectancy of the oldest beneficiary of trust. Depending on the nature and age of the trust beneficiaries, this may result in the loss of an income tax deferral. If the trust does not qualify

as a designated beneficiary, the distributions will have to be completed within 5 years of the decedents death or over the decedents remaining life expectancy. 3. Income taxes may be higher on retirement plan assets distributions retained by the trust. 4. If paid to a credit shelter trust, part of the estate tax exemption is wasted by paying income taxes on the distributions to the trust. 5. For qualified plans, the plan may permit only a lump sum distribution. If paid to outright to a spouse, a tax-free rollover is possible. If paid to a trust a tax-free rollover is not possible and income taxes must be paid. 6. For qualified plans, spousal consent may be required to name a trust as beneficiary. 7. The trustee must determine how to allocate the retirement plan asset distribution between income and principal. 8. The concepts of fiduciary income taxation complicate the taxation of retirement plan asset distributions. a. The fiduciary income tax distribution system and the separate share rule complicates who bears the income tax burden. b. Securing a fiduciary income tax charitable deduction may be challenging. III. Generally, if retirement plan assets are payable to a trust, the trustee will want to keep the retirement plan assets intact and avoid taking any unnecessary distributions. A. Distributions from the retirement plan trigger income taxation. 1. Generally, avoid distributing retirement plan assets to a trust in a lump sum unless you realize that the entire distribution will be subject to income taxation. a. See PLR 200452041 where an IRA was payable to a trust and the IRA custodian advised the trustee to distribute the entire IRA to the trust. After realizing that the distribution constituted a taxable transaction and that the trustee was only required to withdraw annually an amount equal to the minimum required distribution, the trustee asked the IRS to allow the money to be deposited back into the IRA. The IRS informed the taxpayer that the withdrawal could not be undone. Discussing 408(d)(3)(1) and Rev. Proc. 2003-16 relating to a waiver of the 60 day rollover period, the IRS stated that there was no authority which would allow it to override a distribution to a beneficiary named by the IRA owner to receive the distribution on the IRA owners death. It also stated that only a spouse can rollover an IRA

distribution to another IRA and since none of the trust beneficiaries were the IRA owners spouse, the IRA was an inherited IRA for which a rollover is not permitted. 2. Instead, distribute from the retirement plan to the trust only the amount of the minimum required distribution or the amount needed for distributions to the trust beneficiaries (e.g. to satisfy the all income requirement of a marital trust). a. Only the amount distributed will be subject to income tax. The balance will remain in the retirement plan where it can continue to grow on a tax-deferred basis. IV. Income tax consequences of distribution to trust A. Distributions from a retirement plan after the death of the participant (with the exception of distributions from a Roth IRA which are not subject to income taxation) to an estate or trust will be included in the estate or trusts gross income as income in respect of a decedent. See Rev. Rul. 92-47, 1992-1 C.B. 198 (the portion of a lump sum distribution to the beneficiary of a decedent's IRA that equals the amount of the balance in the IRA at the owner's death, including unrealized appreciation and income accrued to that date, minus the aggregate amount of the owner's nondeductible contributions to the IRA, is income under section 408(d)(1) of the Code and is income in respect of a decedent under section 691(a)(1) that is includible in the gross income of the beneficiary for the taxable year the distribution is received). See also PLR 200336020; PLR 200226015; PLR 200210002; PLR 200234019: PLR 199939039; PLR 199901023; PLR 9818009: PLR9723038: PLR 9634019; PLR 9132021. B. Estates and trusts are taxed as separate entities and have their own tax rate schedule. 1(e). A trust reaches the maximum 35% income tax bracket (in 2006) at $10,050 of taxable income. By comparison, a married individual filing jointly would have to have taxable income of $336,550 (in 2006) before he is subject to the maximum 35% income tax bracket. In most cases, retirement plan distributions to a trust, if retained in the trust, will be taxed at a higher rate than if it were distributed to the trust beneficiaries. 1. The higher tax payable at the estate or trust level can be mitigated if: a. The estate or trust makes distributions to an individual beneficiary (who presumably is in a lower marginal income tax bracket) which are deemed to carry out DNI. b. Distributions are made from the estate or trust that qualify for the fiduciary income tax charitable deduction under 642(c). c. The trust is classified as a grantor trust, the income and expenses of which are reportable directly by the holder of the power that renders the trust a grantor trust.

d. A 691(c) deduction is available to the distributee of the retirement plan benefits. C. Discussion: 1. Distributions from retirement plan to an estate or trust enter into the calculation of the estate or trust distributable net income or DNI. Rev. Rul. 92-47, 1992-1 C.B. 198; PLR 200226015; PLR 200210002. 2. An estate or trust is entitled to an income distribution deduction limited by its DNI for any distribution it makes to a beneficiary. 651, 661; PLR 200226015; PLR 200210002. 3. The beneficiary, on the other hand, must account for his share of the amount distributed to him limited by the amount of the estate or trusts DNI allocated to him. 652, 662, 663(c). Thus, the estate or trust gets an income distribution deduction for the amount it distributes to a beneficiary and the beneficiary, in turn, must account for that distribution on his income tax return. b. An exception exists if the trust is a grantor trust. A trust is a grantor trust if the grantor retains certain prohibited powers specified in 673-677. A trust whose beneficiary has the sole unrestricted right to withdraw assets from a trust is treated as a grantor trust. 678(a)(1). If a trust is classified as a grantor trust, the powerholder is treated as the owner of the trust assets and the trusts income and expenses are reported directly by the powerholder (grantor or beneficiary, as the case may be). To the extent the trust is a grantor trust, the distribution from the retirement plan to the trust would automatically flow through and be taxed on the beneficiarys tax return. For example, if the retirement plan is payable to a life estate/lifetime general power of appointment marital trust, the surviving spouses lifetime right to withdraw under the general power of appointment causes the marital trust to be taxed as a grantor trust. In that case, the retirement plan distribution is taxed directly to the surviving spouse due to his or her power to withdraw. 678(a). 4. An estate or trust can make distributions to the beneficiaries and thereby cause the beneficiaries to be taxed on the retirement plan distributions. The distribution shifts the income tax burden to the beneficiaries who will most likely be in a lower marginal tax bracket than the trust. a. If distributions are made, the trust beneficiary reports the amount distributed and the trust gets an income distribution deduction for the amount distributed, both limited by the trusts DNI.

b. If distributions are not made to the beneficiaries, the retirement plan distributions will be accumulated and taxed at the estate or trust level at the estate or trusts compressed income tax rates. 5. As indicated earlier, an IRA distribution paid to an estate or trust enters into the computation of DNI. The amount of the distributions taxed at the estate or trust level or taxed at the beneficiary level depends on the terms of the governing instrument, the amount and timing of distributions and the complicated rules governing the income taxation of trusts and estates. a. Generally, the retirement plan distribution paid to an estate or trust will be taxed to the estate or trust unless it is distributed in the year it is received by the estate or trust or within 65 days after the end of its tax year pursuant to a 663(b) election. Even then, the retirement plan distribution will be taxed at the trust or estate level unless the distributions to the beneficiary are deemed to carry out DNI to the beneficiaries. b. DNI will not be carried out to the beneficiaries if the distribution is a bequest of a specific sum of money. 663(a)(1); Reg. 1.663(a)-1. i. An estate or trust is not entitled to a distribution deduction for a specific bequest and the beneficiary is not taxable on the distribution. ii. A specific bequest falls outside the estate or trusts distribution system. 663(a)(1). This rule only applies if the amount of the specific bequest can be ascertained as of the date of death. Post-death events, such as the election to take administration expenses on either the fiduciary income tax return or the estate tax return, which may change the amount of the bequest, cause the distribution to lose its status as a specific bequest i.e. the distribution is deductible by the estate or trust and taxable to the beneficiary. Thus, a pecuniary marital deduction formula bequest, which is dependent on post-death events for determination of the amount, is not a specific bequest. Thus, distributions to fund a pecuniary marital deduction formula bequest will carry out DNI. 6. If the retirement plan owners estate paid an estate tax, the recipient of the retirement plan distribution may be entitled to an income tax deduction for the estate tax attributable to the retirement plan distribution. a. 691(c) provides an income tax deduction for the estate tax attributable to the receipt of income in respect of a decedent (IRD) i.e. income to which decedent was entitled at the time of his death but was not received by the decedent at the time of his death. The deduction is allowed to the recipient of the IRD in the year of receipt.

b. Distributions from retirement plans and IRAs are income in respect of a decedent to the recipient for which a 691(c) deduction may be available. c. Rule for 691(c) deduction: Where an item of IRD has been included in the Federal estate tax return, the recipient of that item of IRD who subsequently reports it on his income tax return gets an income tax deduction computed under 691(c) equal to the Federal estate tax paid on the IRD. i. The amount of the 691(c) deduction is the excess of the actual Federal estate tax over the Federal estate tax liability excluding the net value of the IRD (IRD less deductions in respect of a decedent (DRD) under 691(b)). 691(c)(2). ii. IRD recipients will share proportionately the total 691(c) deduction, as calculated. iii. In calculating the 691(c) deduction, the decedents top estate tax rates are deemed to have been imposed on the net IRD. iv. If an item of IRD is subject to the generation-skipping tax as a result of a taxable termination or a direct skip, a deduction is allowed for the generation-skipping tax liability associated with the IRD portion of the item. 691(a)(3). The deduction is determined under principles similar to the principles for deducting a portion of the estate tax and is allowed for the portion of the GST tax attributable to items of IRD of the trust that were not included in the gross income of the trust before its termination. This deduction will apply when accrued or undistributed income in a generation-skipping trust is distributed when the interest of the older generation terminates or when IRD items are left to a grandchild or other skip person. d. To whom is the 691(c) deduction allowed? The 691(c) deduction is allowed to the person who receives the IRD. i. 691(c)(1)(B) provides that if an estate or trust receives an item of IRD and the estate or trust distributes part or all of that item of IRD out to a beneficiary of the trust or estate, then the trust or the estate must share the 691(c) deduction with the beneficiary to whom the distribution is made. e. 3 Steps in Computing the 691(c) deduction: i. Compute the federal estate tax in the normal manner i.e. including all IRD under 691(a) on the estate tax return and deducting all deductions in respect of a decedent (DRD) under 691(b).

ii. Recompute the federal estate tax after excluding from the gross estate the "net value of the IRD". The "net value of the IRD" is the 691(a) items included on the estate tax return less the 691(b) items that were deducted on the estate tax return. 691(c)(2)(B). iii. The difference between the federal estate tax computed in (i) and the federal estate tax computed in (ii) is the federal estate tax that was paid on the net value of the IRD. This is the maximum amount of the 691(c) deduction. 691(c)(2)(C). f. The estate tax means the tax imposed on the decedent under 2001 or 2101, reduced by the credits against the tax. 691(c)(2)(A). Thus, both the original estate tax and the redetermined estate tax must take into account all applicable credits i.e. the unified credit, the credit for state death taxes, the credit for prior gift taxes, the credit for tax on prior transfers and the credit for foreign death taxes. g. Notice that the amount of the state death tax credit (prior to its repeal), which does not qualify for the 691(c) deduction, is subject to both Federal income tax and Federal estate tax. h. Note that the 691(c) deduction is computed at the marginal estate tax rate. i. Note that a 691(c) deduction may not be allowed if there is no Federal estate tax payable (due to an unlimited marital deduction or a charitable deduction) or if all of the income earned by the estate or trust is tax exempt. i. When a bequest of an IRD item qualifies for either the marital or charitable deduction, the effect of the deduction must be taken into account in determining the estate tax attributable to inclusion of the item in the gross estate. Regs. 1.691(c)-1(d); 1.691(c)-2; 1.691(c)1(a)(2). There is confusion in the case law as to how this recomputation works in specific cases. See Kincaid v. Comm., 85 TC 25 (1985) (holding that nonresidual marital equal to 50% of the estate did not need to be recomputed when the IRD was part of the residue) and Estate of Cherry v. United States 2000-1 USTC 50223 (W.D. Ky. 2001) (holding that a residual marital which was responsible for estate taxes payable on specific bequests has to be recomputed when the IRD was part of the residue) and Chastain v. Comm. 59 T.C. 461 (1972) (holding that a residual charitable bequest doesnt have to be recomputed when IRD was specifically bequeathed). See also Rev. Rul. 67-242, 1967-2 C.B. 227.. ii. If the marital or charitable deduction is based upon a percentage of the estate, the reduction of the gross estate causes a corresponding reduction in the marital or charitable deduction.

iii. If items of IRD are left specifically to the surviving spouse or charity, in recalculating the Federal estate tax the items of IRD are excluded from the gross estate and from the martial or charitable deduction. Rev. Rul. 67-242, 1967-2 C.B. 227. On the other hand, if the marital or charitable bequest is to be satisfied with IRD items to the extent possible, the marital or charitable deduction should not be reduced if there were enough non-IRD assets to satisfy the bequest. Kincaid v. Comm., 85 TC 25 (1985) and Estate of Cherry v. United States 133 F.Supp. 2d 949 (W.D. Ky. 2001) (which applied Reg. 1.691(c)-1(a)(2) in deciding that the redetermined estate tax should be determined by reducing the marital deduction by the items of IRD). iv. If the estate is entitled to the maximum marital or charitable deduction so that no estate tax is due, there will be no 691(c) deduction. j. Allocation of the 691(c) deduction. If all of the IRD is recognized by one beneficiary in one year, the entire 691(c) deduction is deducted in the year the IRD is received. In the event the IRD is payable to multiple beneficiaries or in difference taxable years, the total 691(c) is allocated among the recipients and among the taxable years of receipt. Each IRD recipient will receive a proportionate share of the 691(c) deduction attributable to IRD items received each year. 691(c)(1)(A). Allocation of the 691(c) deduction among the various beneficiaries who receive the IRD is as follows per 691(c)(1)(A): Formula: Amt of IRD Actually Received By Recipient During Taxable Year But Not In Excess of FET Value of Item Estate Tax Value of all IRD (691(a) items not net IRD)

Estate Tax Paid Which is Attributable To Net Value of IRD (Total 691(c) Deduction)

691(c) Deduction for Recipient

i. The allocation formula may not treat all beneficiaries equitably. For example, as illustrated in Rev. Rul. 67-242, 1967-2 C.B. 227, the surviving spouse who receives an item of IRD may be entitled to a 691(c) deduction even though the item of IRD qualified for the marital deduction and generated no estate tax liability.

Example: Decedent leaves $35,000 of IRD items, $15,000 to his wife, $15,000 to his son and $5,000 to his daughter. The $15,000 of IRD left to his wife qualifies for the marital deduction and thus is excluded from the gross estate in determining the recomputed estate tax. Assuming the total 691(c) deduction on the $20,000 of IRD ($35,000 IRD less the $15,000 IRD payable to the surviving spouse which must be subtracted from both the gross estate and marital deduction in redetermining the estate tax) is $7,000, the spouse and the son would each be entitled to a 691(c) deduction of $3,000 ($15,000/$35,000 x $7,000) and the daughter would be entitled to a 691(c) deduction of $1,000 ($5,000/$35,000 x $7,000). Notice that the surviving spouse gets a share of the 691(c) deduction even though the amount of IRD payable to her qualified for the marital deduction and did not generate an estate tax. Although the spouse is getting a 691(c) deduction that should belong to the other beneficiaries, the allocation is the result of the language of the statute which allocates the 691(c) deduction on the basis of the value included in the gross estate rather than on the value taken into account in determining the 691(c) allocable among the IRD recipients. ii. If the IRD is received by the recipient over a number of years, the 691(c) deduction is apportioned over the years of receipt in accordance with the allocation formula specified above. iii. Allocation of IRD and the 691(c) deduction for IRD payable to an estate or trust. See generally Reg. 1.691(c)-2. (a) If an item of IRD (e.g. distribution from an IRA) is payable to an estate or trust and is not distributed in the year of receipt, the IRD will be taxed to the estate or trust and the 691(c) deduction will be deductible by the estate or trust. (b) If an item of IRD is payable to an estate or trust and is distributed in its entirety to an estate or trust beneficiary in the year of its receipt, the IRD enters into the calculation of distributable net income (DNI) (unless it is capital gain income) and is passed out to the beneficiary. In addition, the 691(c) is also passed out to the beneficiary. (c) If an item of IRD is payable to an estate or trust and is partially distributed to an estate or trust beneficiary, the IRD enters into the calculation of DNI (unless it is capital gain income) and a portion of the IRD and the 691(c) deduction will be passed out to the beneficiary based on the distribution rules of 651, 652, 661 and 662. 691(c) (1)(B); Reg. 1.691(c)-2(a)(1)

Example: The executor of an estate receives taxable interest of $5,500 and IRD (from an IRA distribution) of $4,500 during the taxable year. The 691(c) deduction is $1,500. The executor makes a discretionary distribution of $2,000 to the sole beneficiary during the year. The DNI of the estate is $10,000 consisting of taxable interest of $5,500 and IRD of $4,500. The amount of the distribution deduction allowed to the estate under 661(a) and the amount taxable to the beneficiary under 662(a) is $2,000 as DNI exceeds the amount of the distribution. The balance of the DNI of $8,000 is taxable to the estate. IRD makes up 45% of the DNI ($4,500/$10,000). Thus, of the $2,000 distributed to the beneficiary, $900 (45% x $2,000) is IRD and the $1,100 balance is taxable interest. In addition, $300 ($900/$4,500 x $1,500) of the 691(c) deduction is allocated to and may be deduced by the beneficiary and the $1,200 balance of the 691(c) attributable to the estate ($3,600/$4,500 x $1,500) is allocated to and may be deducted by the estate. The estates taxable income of $6,200 is calculated as follows: $10,000 gross income less $2,000 distribution deduction less $1,200 691(c) deduction less $600 exemption. Notice that the executor can control who gets taxed on the IRD. If the executor retains the IRD, the estate pays the tax on the IRD and gets the 691(c) deduction. On the other hand, if the executor distributes the IRD to a beneficiary who then collects the IRD, the beneficiary pays the tax on the IRD and gets the 691(c) deduction. Reg. 1.691(c)-2(d), Example 1. (i) Note that the distribution of the right to IRD (as opposed to the actual receipt of IRD) is not a distribution for purposes of Subpart C of Part 1 of Subchapter J. This means that an estate or trust that distributes the right to IRD is not entitled to an income tax distribution deduction and the amount is not included in the income of the recipient beneficiary. In other words, the distribution rules of 651, 652, 661 and 662 do not apply to the right to IRD. Rollert Residuary Trust v. Commissioner, 80 T.C. 619 (1983) affd 752 F. 2d 1128 (6th Cir. 1985). See also PLR 200234019 (estate not taxed on IRA where executor assigned the IRA to a charity) and PLR 200452004. For example, the distribution of an installment note to a beneficiary of the estate is not subject to the distribution rules. Instead, the

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beneficiary reports the deferred gain or distribution from the IRA upon receipt. (ii) If the IRD is allocated to principal of the estate or trust and is distributed to a beneficiary in a subsequent year, the 691(c) deduction is allocable only to the estate or trust. Reg. 1.691(c)-2(a)(3). k. The 691(c) deduction attributable to ordinary income is deductible by an individual as a miscellaneous itemized deduction not subject to the 2% floor. 67(b)(7); Rev. Rul. 78-203, 1978-1 C.B. 199. Also, the 691(c) deduction is excluded by 56(b)(1)(A)(i) from treatment as a miscellaneous itemized deduction for purposes of the alternative minimum tax. Note that no benefit from the 691(c) deduction is realized if the recipient of the IRD does not itemize his deductions i.e. he claims the standard deduction. Also note that, although the 691(c) deduction is not subject to the 2% floor, it is subject to the reduction of 3% of adjusted gross income in excess of (for 2006) $150,500. 68. If an IRD recipient is in a high enough tax bracket, the 68 limitation may result in the loss of a portion of the 691(c) deduction. 7. Securing the fiduciary income tax charitable deduction under 642(c) for an IRA payable to an estate or trust followed by a distribution to charity. a. Often, a retirement plan owner will designate his estate or trust as the beneficiary of his retirement plan with the estate or trust paying a portion or the entire residue of the estate or trust to charity. If retirement plan distributions are made to the estate or trust and then to charity, the estate or trust will want to make sure it qualifies for the fiduciary income tax charitable deduction allowed under 642(c). Many practitioners are unaware of the requirements for the 642(c) deduction. As a result the fiduciary income tax charitable deduction under 642(c) may be lost thereby causing the retirement plan to take a tax haircut before it is transferred to charity. i. It is much easier to leave retirement plan benefits directly to charity than to leave them to an estate or trust and rely on the fiduciary income tax charitable deduction to avoid an income tax on the benefits. b. An estate or trust may receive a fiduciary income tax charitable deduction under 642(c) for an IRA distributed from the estate or trust to charity if the IRA is deemed distributed to charity. To qualify for a fiduciary income tax charitable deduction under 642(c), the following requirements must be met: (1) the bequest must be paid out of gross (taxable) income and (2) the charitable bequest is "paid pursuant to the terms of the governing instrument" i.e. there must be authority in the will or trust to make the distribution to the charity.

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i. The 642(c) deduction is unlimited in amount, unlike the percentage limitations that apply to charitable deductions for individuals. ii. The 642(c) deduction differs for estates and trusts. Generally, an estate is entitled to a fiduciary income tax charitable deduction for amounts that are "paid or permanently set aside" for charity. In other words, as estate is entitled to a 642(c) deduction for amounts actually paid to charity in the current year or amounts that are set aside for charity and will actually be paid sometime in the future. Generally, post-1969 trusts are entitled to a 642(c) deduction only if the trust pays the amount to charity in the current year on in the following year. Thus, a post-1969 trust generally will not be entitled to a 642(c) deduction for amounts "permanently set aside" for charity. c. Even though the charitable bequest is paid out of gross income (in the tax sense), the fiduciary income tax charitable deduction will be denied unless the will or trust directs that the retirement plan assets be paid to charity i.e. the bequest satisfies the requirement that it is made pursuant to the governing instrument. d. The United State Supreme Court has held that if the fiduciary has the discretion to pay the amounts to charity and does, in fact, pay it to charity, it will be considered to have been paid pursuant to the terms of the governing instrument. Old Colony Trust 301 U.S. 379 (1937). e. If the bequest does not meet the two requirements of 642(c), the estate or trust will lose the charitable deduction and will pay income tax on the IRA distribution at the estate or trust level leaving less available for charity. f. The obvious goal is to make sure the fiduciary income tax charitable deduction is secure. To secure the fiduciary income tax charitable deduction, the retirement plan should be specifically left to charity. Reg. 1.642(c)3(b)(2). The best way to do that is to include a provision in the governing instrument that the retirement plan assets be left to charity. Sample language might be something like the following: To the extent possible, gifts to charitable organizations shall be satisfied by distributions of property constituting income in respect of a decedent as that term is defined by 691 of the Internal Revenue Code of 1986 as amended from time to time. This clause will require retirement plan assets (income in respect of a decedent) be used to fund a charitable gift. g. If the requirements for a fiduciary income tax charitable deduction under 642(c) are not satisfied, an estate or trust will not be able to take an income

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distribution deduction for an amount distributed to a charity. Reg. 1.663(a)-2. United States Trust Company v. United States 803 F. 2d 1363 (5th Cir. 1986); Rebecca K. Crown Income Charitable Fund v. Comm. 98 T.C. 327 (1992); Estate of OConnor v. Comm. 69 T.C. 165 (1977); Mott v. United States 462 F.2d 512 (Ct.Cl. 1972); Weir Foundation v. United States 508 F.2d 894 (2d Cir. 1974); Pullen v. United States 80-1 USTC 9105 (D.Neb. 1079), affd mem. 634 F.2d 632 (8th Cir. 1980); Rev. Rul. 68-667, 1968-2 C.B. 289. h. There may be a problem securing a fiduciary income tax charitable deduction for the transfer of retirement plan benefits from an estate or trust to a charitable remainder trust. There is no authority allowing a fiduciary income tax charitable deduction for the transfer of retirement plan benefits (or other income in respect of a decedent) to a charitable remainder trust. i. See TAM 8810006 where the IRS allowed a distribution deduction under 661(a) for a distribution to a charitable remainder annuity trust. If a distribution deduction is available for the amount distributed to the charitable remainder trust, the retirement plan benefits would have to be distributed in the year of receipt of the IRA (or within 65 days after the end of the year of receipt) to avoid taxation at the trust or estate level. A fiduciary income tax charitable deduction will not be allowed for the transfer from an estate or trust to a charitable remainder trust that allows for invasions of principal to make the payments to the noncharitable beneficiary because the ability to invade principal means that the amount is not permanently set aside for charitable purposes. Reg. 1.642(c)-2(d). With the exception of an income only unitrust, there is always a possibility of an invasion of principal to meet the charitable remainder trust annuity or unitrust payout requirements.

ii.

i. In PLR 9836040 a trust instrument provided that all income in respect of a decedent be distributed to charity. The grantors profit sharing plan was payable to the grantors trust. While not ruling on the issue, the ruling points out the possibility that the trust may qualify for a fiduciary income tax charitable deduction under 642(c) if the trust made a timely distribution to a private foundation of the amount distributed from the profit sharing plan to the trust. The trust would qualify for a 642(c) deduction as the charitable contribution was made out of gross income (the profit sharing plan assets were taxable income) and they were made pursuant to the governing instrument (the trust mandated that IRD be distributed to charity). See also PLR 200336020 where an IRA distribution was included in the gross income of an estate but qualified for the fiduciary income tax charitable deduction under 642(c).

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j. Note that the rules for the fiduciary income tax charitable deduction under 642(c) differ for estates and trusts. k. An estate may take a fiduciary income tax charitable deduction for amounts paid or permanently set aside for charity. 642(c)(2). Thus, a fiduciary income tax charitable deduction is allowed for retirement plan assets that are actually paid to charity in the current year or that are permanently set aside by the estate for charity. It is not necessary that the retirement plan benefits be paid in the current year the charitable deduction is allowed if the amount is permanently set aside for charity. l. As a general rule, trusts must actually pay the amount to charity in the year the retirement plan assets are distributed to the trust or in the immediately following year. 642(c)(1). Generally, there is no set aside rule for trusts as there is for an estate. However, if the trust is eligible to and does make a 645 election to be treated as an estate, the rules governing the fiduciary income tax charitable deduction for an estate will apply. It should be noted that there is an extremely limited set aside deduction available for trusts created after October 9, 1969 and that pre-October 9, 1969 trusts may be able to obtain a set aside deduction under a grandfather exception. m. If retirement plan benefits payable to an estate or trust do not qualify for the fiduciary income tax charitable deduction under 642(c), there are two ways to avoid the income tax on retirement benefits payable to an estate or trust: (1) assign the retirement plan benefits to charity or (2) pay the charity last. i. Assign the retirement benefits to charity. In PLR 200234019 the decedent named his estate as the beneficiary of his IRA. The decedents will left a percent of his estate to various charities. The decedents will authorized the estate to make non-pro-rata distributions. Pursuant to Rev. Rul. 69486, no exchange is deemed to occur when an executor makes non-prorata distribution if such distributions are allowed by the governing instrument or state law. The IRS held in the ruling that the executor could assign the IRA to the charitable beneficiary and when the charity took the distribution from the IRA there would be no taxable income to the estate or the individual beneficiaries and, since the charity is tax-exempt, there is no taxable income to the charity. The IRS relied on the regulations that state that if income in respect of a decedent is transferred to a specific or residuary legatee, only the recipient (the charity in this case) must report such income. ii. Pay the charity last. In PLR 200221011 the decedents will left specific bequests to individuals and the residue to charity. The decedent named his estate as the beneficiary of the IRA. In Year 1 the executor paid all administration expenses and all specific bequests to the individual beneficiaries. Thus, charity was the only remaining beneficiary left at the

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end of Year 1. The estate received the IRA proceeds in Year 2. The IRS held that the estate is entitled to the charitable set aside deduction and that offsets the inclusion of the IRA proceeds in the estates gross income. n. Conclusion: The easiest way to avoid income taxation on retirement plan assets intended to be left to charity is to name the charity directly as the beneficiary of the retirement plan benefits. If they pass to an estate or trust, they should be structured in such a way that they qualify for the fiduciary income tax charitable deduction under 642(c). If the requirements of 642(c) are not met, consider assigning the benefits to charity (see PLR 200234019) or paying the charity last (see PLR 200221011). 8. IRD payable to a charitable remainder trust (CRT). a. Naming a charity as the beneficiary of IRD allows the IRD to qualify for an estate tax charitable deduction under 2055. In addition, since a charity is tax exempt, the IRD will not be subject to income taxation. Naming a CRT as the beneficiary allows the IRD to qualify for an estate tax charitable deduction under 2055 equal to the actuarial value of the remainder interest. In addition, since the CRT is a tax exempt entity, the IRD will not be subject to income taxation when the IRD is distributed to the CRT. See PLRs 9237020, 9253038, 9341008, 9633006, 9634019, 9723038, 9818009, 199901023 and 199939039. b. Caution should be used in drafting for the disposition of IRD to a charity. If the bequest is deemed to be a pecuniary bequest, funding the bequest (as discussed below) with the right to IRD may cause the transferor to recognize gain. In that case, the IRD will be taxed to the estate or trust unless the distribution to the estate or trust qualifies for the 642(c) fiduciary income tax charitable deduction. In addition, unless the bequest is in the form of a specific bequest or a fraction of the IRD or a residuary bequest, the funding of the bequest may constitute a taxable transfer of IRD under 691(a)(2). c. The tax consequences of paying IRD to a charitable remainder trust were addressed in PLR 199901023. In that ruling the IRS stated that the amount of gross income reduced by the 691(c) deduction is included in tier one income of the charitable remainder trust. More specifically, the ruling stated that under 691(a)(3) the ordinary income character of the IRD is retained. The IRD constitutes ordinary income under 664(b)(1) i.e. it is tier one income. Furthermore, the trust (not the income beneficiary) is entitled to the 691(c) deduction. As a result, the IRD that constitutes ordinary income to the charitable remainder trust is the amount of IRD reduced by the 691(c) deduction. Under the ruling, the 691(c) is not available to the income beneficiary. Although offsetting the IRD received by the CRT with the 691(c) deduction at the tier one level appears advantageous, if the CRT itself earns enough other ordinary income to make its distributions to the

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beneficiary, the IRD deduction will never benefit the CRT income beneficiary. See also PLR 9634019. 9. Coordination with the separate share rule. a. If a single trust has more than one beneficiary and if different beneficiaries have substantially separate and independent shares, their shares are treated separately for the sole purpose of determining the amount of DNI allocable to the beneficiaries under 661 and 662. Reg. 1.663(c)-1(a). i. 663(c) states that for the sole purpose of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Thus, the effect of the separate share rule is to treat multiple beneficiaries of a single trust or estate as if each were the sole beneficiary of a single trust for the purposes of determining how much DNI each distribution carries out. The separate share rule prevents one trust or estate beneficiary who receives a distribution from receiving more than his pro-rata share of DNI. b. Without the separate share rule, disproportionate distributions to beneficiaries from a trust or estate can lead to disproportionate tax treatment for the beneficiaries. c. If separate shares exist, DNI is computed separately for each share. Reg. 1.663(c)-2(b)(5). d. Traditionally, the separate share rule applied only to trusts. Effective for decedents dying after August 5, 1997, the separate share rule now applies to estates as well. e. After the fiduciary has identified the separate shares, the fiduciary must allocate the items of income and deductions among those shares to compute the DNI for each share. In computing DNI for each separate share, the portion of gross income that is income under Section 643(b) must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable local law. Reg. 1.663(c)-2(b)(2). f. An important exception to the allocation rules applies to income in respect of a decedent (IRD). The final regulations provide that IRD is allocated among the separate shares that could potentially be funded with these amounts irrespective of whether the share is entitled to receive any income under the terms of the governing instrument or applicable local law. The amount of gross income allocated to each share is based on the relative value of each

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share that could potentially be funded with such amounts. Reg. 1.663(c)2(b)(3). i. In the absence of a provision in the governing instrument allocating IRD to a specific share, IRD will be allocated to any share that could potentially be funded with IRD. This could shift income tax liabilities to trusts that are protected from estate tax or GST tax by the decedents exemptions. Practitioners may want to draft to limit or eliminate the potential recipients of IRD. ii. Although the final regulations do not address the issue directly, expenses that are directly attributable to items of IRD presumably should be allocated in the same manner as the IRD itself i.e. those expenses would be allocated among the separate shares that could potentially be funded with the IRD in proportion to the relative values of those shares. Example: Ds will directs the executor to divide the residue of the estate equally between Ds two children, A and B. The will directs the executor to fund As share first with the proceeds of Ds IRA. The FMV of the estate is $9,000,000. During the year, the $900,000 balance in Ds IRA is distributed to the estate which is allocable to corpus under local law. The estate has 2 separate shares: one for A and one for B. If any distributions are made to either A or B during the year, then for purposes of determining the DNI for each separate share, the $900,000 of IRD must be allocated to As share. If the will did not direct the executor to fund As share with the IRA proceeds (and assuming state law was silent on the allocation issue), a distribution to either A or B would cause the IRD to be allocated between the two shares to the extent that they could potentially be funded with the IRA proceeds regardless of which share actually received the IRD. Thus, specific direction in the governing instrument about allocating IRD will be recognized as overriding the regulations requirement of allocating IRD among all the potential recipients. Reg. 1.663(c)-5, Example 9 and 10. g. Thus, if the separate share rule applies to a beneficiary and the governing instrument does not specify the allocation of the IRD, a fiduciary is no longer able to control the recipient of IRD by making disproportionate distributions during the year the trust or estate recognizes IRD. h. However, it is still possible to control the recipient of IRD if the right to IRD (as opposed to the IRD itself) is distributed. In other words, if an executor or trustee assigns IRD to a share, the entire IRD will be recognized by that particular share as the IRD is collected. See PLR 200234019 (authorizing the

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assignment of IRD to charity) and PLR 200452004. This assumes, of course, that the transfer of the right to the IRD does not accelerate the recognition of the IRD to the transferor under 691(a)(2). i. The final separate share regulations require the practitioner to pay careful attention to the income tax aspects of IRD. The issues that can arise are illustrated by Examples 6, 9 and 10 of Reg. 1.663(c)-5. As illustrated above, Example 9 indicates that a specific direction in the governing instrument allocating IRD will be recognized as overriding the regulations requirement of allocation among potential recipients. In Example 9 the estate received a distribution from an IRA. The will provided for distribution of the residue in equal shares to the decedents two children. The will also directed that one childs share be funded first with the IRA proceeds. The results in Example 9 confirm that the IRA income will be allocated to that childs share, instead of being allocated equally to each child as would have been required absent the direction in the will to allocate the IRD to one particular child. See Reg. 1.663(c)-5, Example 6. Often practitioners intentionally fund gifts or bequests of IRD to the surviving spouse, especially if this can be done without triggering an income tax. This is usually accomplished by making a specific bequest of the IRD to the spouse. Leaving IRD to a surviving spouse allows the estate of the surviving spouse to be reduced by the income tax that will have to be paid on the IRD thereby decreasing the potential future estate tax on the spouses death. This also avoids wasting the decedents unified credit or GST exemption on amounts that will be paid to the government as income tax. Thus, a specific bequest of IRD or a specific direction about using IRD in funding is now necessary to avoid the final regulations requirement mandating a proportionate allocation of IRD among all potential recipients. j. This is especially important in the case of an estate or trust which would like to transfer IRD to a charity and qualify for the fiduciary income tax charitable deduction under 642(c). Distributions from an estate or trust to charity do not qualify for the income distribution deduction under 661. The only way to obtain a fiduciary income tax charitable deduction is under 642(c). Reg. 1.663(a)-2; United States Trust Company v. United States 803 F.2d 1363 (5th Cir. 1986); Rebecca K. Crown Income Charitable Fund v. Comm. 98 T.C. 327 (1992); Estate of OConnor v. Comm 69 T.C. 165 (1977); Mott v. United States 462 F.2d 512 (Ct. Cl. 1972); Weir Foundation v. United States 508 F.2d. 894 (2d Cir. 1974); Pullen v. United States 80-1 USTC 9105 (D. Neb. 1979), affd 634 F.2d 632 (8th Cir. 1980); Rev. Rul. 68-667, 1968-2 C.B. 289. Example: Decedent dies leaving $1,000,000 in stock and a $1,000,000 IRA to his trust. The trust terminates at Decedents death leaving 50% of his estate to charity and 50% to his son. The trust receives the proceeds of the IRA in 2006 (causing the full $1,000,000 to be included in the trusts taxable income for 2006) and transfers $1,000,000 of IRA proceeds to charity and $1,000,000 of stock to

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the son. The estate wants the $1,000,000 transferred to the charity to qualify for the fiduciary income tax charitable deduction under 642(c). The trust instrument does not direct which share gets the IRA. Thus, each share could potentially be funded with the IRA proceeds. Under the final separate share rule regulations, only $500,000 of the $1,000,000 distributed to charity amount would qualify for the 642(c) deduction as that is all that is deemed paid to charity. On the other hand, if the trust directed that the trustee fund the charitys share with the IRA proceeds (e.g. a specific allocation of IRD), the full $1,000,000 distribution would qualify for the 642(c) deduction. Alternatively, if the trustee did not cash out the IRA and receive the IRA proceeds in the trust, he could have assigned the right to receive the IRA proceeds to the charity assuming the trustee had the right to do so under the governing instrument or state law. In that case, the proceeds of the IRA would be distributed directly from the IRA to the charity where it would avoid income taxation due to the charitys exemption from income tax. PLR 200234019 and PLR 200452004. Note that since the bequest to charity is specified in the trust instrument and is in the form of a fraction, the transfer of the IRD from the trust to the charity is not considered a transfer that would accelerate the recognition of the IRA income at the trust level under 691(a)(2). If the intent is to qualify for the fiduciary income tax charitable deduction under 642(c), the trust document should specify that IRD be used to fund any charitable bequest. Alternatively, the trustee may want to assign IRD to the charity. 10. Allocating IRD to the marital share or to the surviving spouse. a. Allocating the right to IRD to the marital share causes the marital trust or the surviving spouse to bear the burden of the income tax on the IRD. This results in the reduction of the value of the marital share included in the surviving spouses estate while maximizing the value of the non-marital share which is not included in the surviving spouses estate. b. If there are sufficient other assets available to fund the marital share, allocating IRD to the marital share will not result in the reduction of the 691(c) deduction. Kincaid v. Comm. 85 T.C. 25 (1985). See also TAM 7827008 and G. R. Robinson v. Comm. 69 T.C. 222 (1977). 11. Funding a pecuniary bequest with IRD a. If an estate or trust funds a pecuniary bequest with the right to IRD, the traditional view is that the funding accelerates the recognition of the IRD at the estate or trust level. This conclusion is reached in one of two ways: (1) under Reg. 1.661(a)-2(f) (which provides that an estate or trust must recognize taxable income upon funding a specific dollar amount (e.g. a specific bequest) with appreciated property or under 691(a)(2) (which, subject to certain exceptions, taxes the transfer of IRD). See GCM 39388 (May 25, 1984) (IRS concluded that a trust had to recognize gain when it distributed appreciated

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stock in satisfaction of a direction in the trust instrument to pay net income to the beneficiary); Rev. Rul. 83-75, 1983-1 C.B. 114 (in which the IRS concluded that a distribution of appreciated securities by a trust to a charity in lieu of current income resulted in taxable gain to the trust); Kenan v. Commissioner 114 F.2d 217 (2nd Cir 1940). b. This issue usually arises when the decedent names his living trust as the beneficiary of IRD and the trust splits into a pecuniary marital and a credit shelter trust after the decedents death. If the trustee uses the right to receive IRD to fund the pecuniary marital, the recognition of income issue arises. This same issue would arise if the trust provides for a pecuniary bequest to charity (and the trust does not require charitable bequests to be satisfied with IRD) and the trustee uses the right to receive IRD to fund the pecuniary charitable gift. c. It appears that those who rely on Kenan and Reg. 1.661(a)-2(f) assume that funding a pecuniary bequest with IRD will be treated the same as a bequest funded with appreciated non-IRD assets (i.e. gain will be required to be recognized). However, there doesnt appear to be statutory authority for this result. In fact, according to one case the taxation of right to receive income in respect of a decedent appears to be governed exclusively by 691. Rollert Residuary Trust 752 F2d 1128 (6th Cir. 1985). If IRD is governed exclusively by 691, it appears that only 691(a)(2) would govern the recognition of any gain and 691(a)(2) specifically exempts receipt of amounts by bequest, devise or inheritance from its provisions. Thus, it does not appear that Reg. 1.661(a)-2(f) governs the taxation of IRD. d. 691(a)(2) taxes the transfer of IRD. A transfer under 691(a)(2) is defined as a sale, exchange or other disposition. However, 691(a)(2) says that a transfer of IRD made to a person pursuant to the right of such person to receive such amount by bequest, devise or inheritance is not a taxable transfer under 691(a)(2). It is questionable whether the funding of a pecuniary bequest with IRD would result in the recognition of income under 691(a)(2) as it would seem that the trust is receiving the amount by bequest, devise or inheritance thereby satisfying an exception under 691(a)(2). e. However, until the issue is finally settled, it is better to take a safe approach and avoid the issue altogether. f. The acceleration of income problem for an estate or trust can be avoided if the bequest of the IRD is a specific bequest. Reason: a specific bequest of the IRD does not result in the acceleration of the IRD. See 691(a)(2); Reg. 1.691(a)-4(b). g. Alternatively, structuring the bequest as a fractional or residuary bequest will avoid the recognition issue.

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h. Generally, the distribution of a right to receive IRD (as opposed to distributing the IRD that has been collected) will not accelerate the recognition of the IRD by the distributing trust or estate if (1) the items of IRD is specifically bequeathed and the fiduciary distributes the claim to the legatee or (2) if the IRD is part of the residue of the trust or estate and the fiduciary distributes the claim to the residuary legatee. Reg. 1.691(a)-4(b). Reg. 1.691(a)-2(b) Ex. 1 and 2. i. Thus, the fiduciary can fund a specific bequest, fractional bequest or residuary bequest with the right to receive future payments of IRD without triggering income to the distributing estate or trust. Reg. 1.691(a)-4(b)(2); PLR 9537005. j. To prevent the funding of a pecuniary bequest with income in respect of a decedent from resulting in the recognition of income, consider including language in the governing instrument that provides that to the extent possible, pecuniary gifts shall be satisfied by distribution of property constituting income in respect of a decedent. Such a clause establishes the decedents intent to make a specific bequest of the IRD rather than have it treated as a pecuniary bequest funded with the right to receive income in respect of a decedent. Alternatively, the executor or trustee could assign the right to IRD to the pecuniary beneficiary without the recognition of income. PLR 200234019. IV. Concept of Trust Accounting Income as Applied to Retirement Benefits A. How is trust accounting income (TAI) determined? 1. The trust instrument governs the definition of trust accounting income if there is a provision in the trust instrument defining trust accounting income as it relates to retirement assets. a. A careful draftsman will anticipate that a trust may be the beneficiary of retirement plan assets and specifically include language in the trust document defining trust accounting income and what constitutes a retirement plan subject to the special definition and how a retirement plan distribution is to be divided between income and principal. 2. State law will govern if the trust instrument is silent a. The 1997 version of the Uniform Principal and Income Act (UPIA) allocates 10% of any required distribution from a retirement plan to income. 90% of required distributions and 100% of non-required distributions are allocated to principal. For example, see 1340.71 of the Ohio Revised Code for the Ohio version of the Uniform Principal and Income Act.

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(1) Under the law of most states that have adopted the 1997 version of the UPIA, the automatic 90%/10% or 100% allocation rule is applicable only if the trustee is unable to determine the actual amount of income earned by the retirement plan and included in the distribution. The trustee must first look to the retirement plan administrator for a characterization of the amount of interest, dividends or payment made in lieu of interest or dividends, and if unsuccessful in making that determination, make a good faith effort to determine the amount of the distribution that constitutes accounting income. Only if those steps prove unsuccessful is the trustee allowed to adopt the 90%/10% allocation for required distributions and the 100% allocation to principal for distributions from the retirement plan that are not required. (2) Note the problem if a trustee must resort to the 1997 version of the UPIA to determine the amount of the retirement plan distribution allocable to income and principal. If, for example, an IRA is payable to a QTIP and the trustee received a $10,000 distribution from the IRA, the trustee would allocate 10% of the $10,000 distribution, or $1,000, to income and 90% of the $10,000 distribution, or $9,000, to principal. If the surviving spouse had no rights to principal, he or she would only be entitled to a distribution of $1,000, the amount of the distribution allocated to income under the UPIA. The remaining $9,000 would be trapped and taxed at the trust level. To avoid the application of the UPIA, it is advisable for trust documents to contain provisions defining trust accounting income and, more specifically, a provision detailing how to allocate retirement plan distributions between income and principal. B. Determining trust accounting income at retirement plan level 1. The trustees allocation of retirement plan distributions between income and principal will be easy if the retirement plan provider uses traditional trust accounting principles for its retirement plan statements. For example, Mellon uses traditional trust accounting principles in preparing the periodic accounting statements for IRA accounts i.e. the periodic statements have an income ledger and principal ledger and receipts and disbursements are accounted for as either income or principal. Thus, there is a historical record of receipts and disbursements that are reflected as either income or principal items. a. A trustee receiving a distribution from an IRA held by an IRA provider using traditional trust accounting can quickly determine if the distribution came from income or principal and may allocate the distribution accordingly in the trust.

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b. Note that using traditional trust accounting principles at the retirement plan level enables the trustee to control who bears the burden of the income tax. For example, if an IRA distribution is payable to a trust (which requires all income to be distributed to the beneficiary), a trustee can intentionally cause the beneficiary to be taxed on the distribution by taking the IRA distribution from the accounting income of the IRA. A distribution of accounting income from an IRA account would become accounting income in the trust for trust accounting purposes. Since the trust is required to distribute all the income to the surviving spouse, the IRA distribution will be distributed to the beneficiary who will report the distribution on his or her own individual income tax return and enjoy the benefit of any corresponding 691(c) deduction. 2. IRAs held by mutual fund companies present more of a challenge. Generally, mutual fund statements do not account separately for income and principal. An IRA statement typically shows the value of the fund shares, the total shares owned and the total value of the assets in the IRA. They do not contain a historical record of the income and principal transactions in the IRA. Thus, the trustees job in allocating a distribution between income and principal of the trust is more difficult. The trustee must request the fund to provide that historical record and that may be difficult or impossible to obtain. 3. Some general principles: a. Generally, the value of the IRA at the death of the IRA owner should all be principal. b. After death, the IRA should account for income and principal separately. c. A trustee of the trust which is the beneficiary of an IRA held by a mutual fund company or other IRA provider that does not use traditional trust accounting should consider transferring the IRA to an IRA provider that accounts separately for income and principal in the IRA. The trustees administration duties will be significantly simplified if the IRA provider uses traditional trust accounting principles. C. Why allocation of retirement plan distributions between income and principal is important. 1. Allocation of retirement plan distributions between income and principal is important because such an allocation determines who gets what from the trust. The terms of the trust determine who has a right to income or principal. Trust accounting principles indirectly plays a role in who gets the distribution and how much makes up the distribution. 2. Distributions to a trust beneficiary generally carries out DNI

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i. ii.

Amount retained in the trust is taxed to the trust at potentially higher rates. Different distribution requirements yield different cash flow and tax results. Whether a distribution is mandatory or discretionary affects not only the amount payable to the beneficiary but also who bears the tax burden on the taxable income.

3. If the trust is intended to qualify for the marital deduction as a life estate/general power of appointment, a QTIP trust or a QDOT, the determination of accounting income has estate tax ramifications. D. Examples 1. Example: An irrevocable trust provides that net income is payable to A with the remainder payable to As issue. A is entitled only to trust accounting income he has no rights to principal. The trust is the beneficiary of an IRA. IRA distributions to the trust must be allocated between income and principal. If the trust instrument defines TAI, that provision governs the allocation of the IRA distribution between income and principal. If the trust does not define TAI, state law (e.g. the local version of the Uniform Principal and Income Act) governs the allocation of the IRA distribution between income and principal. A is entitled to income only from this trust he is not entitled to a distribution from principal. The portion of the IRA distribution allocated to income of the trust will be distributed to A as the income beneficiary and he will pay tax on the distribution of income. The portion of the IRA allocated to principal will be accumulated by the trust and the trust will pay tax (at its higher rates) on the portion of the IRA distribution allocated to principal. 2. Example: An irrevocable trust provides that net income is payable to A with the principal payable to A in the trustees discretion and the remainder is payable to As issue. The trust is the beneficiary of an IRA. In this example the trustee could distribute to A any amount received as a distribution from the IRA, even if such amounts were allocated to trust principal, assuming the principal distribution satisfied the discretionary standard. If the trustee makes a discretionary distribution of principal along with the required distribution of income, the distribution from the IRA to the trust will be included in trust DNI, the distribution from the trust to A will cause A to be taxed on the distribution (to the extent of trust DNI), the trust will receive an income distribution deduction (to the extent of DNI) for the distribution to A. If the right to distribute principal is governed by a narrower standard (e.g. education), a principal distribution could not be made unless the discretionary standard is met. If the standard is not met, the portion of the IRA distribution allocated to principal would be accumulated and taxed at the trust level, most likely at the higher trust income tax rates. If the intent is to minimize income taxes on the IRA distribution, the trust should either contain a flexible discretionary principal distribution standard or state the

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grantors intent that principal distributions may be utilized to reduce the income tax on the IRA distribution. 3. Example: An irrevocable trust that net income is payable to A with the remainder payable to As issue. A is only entitled to trust accounting income. The trust is the beneficiary of an IRA. The trust receives a minimum required distribution (MRD) from the IRA. However, the accounting income of the IRA exceeds the minimum required distributions for the year. Since the IRA is a trust asset, the income beneficiary is entitled to not only the accounting income in the trust but also to the accounting income in the IRA. Thus, the trustee must request the excess accounting income from the IRA and pay this, as well as the portion of the minimum required distribution payable to the trust and allocated to trust accounting income, to A as the income beneficiary of the trust. V. Determining the minimum required distribution when an IRA is payable to a trust. A. The minimum required distribution rules of 401(a)(9) require that distributions from a retirement plan commence after a participants death. The period of time over which the payments must be taken depends on (1) whether there is a designated beneficiary and (2) whether the participant died before or after his required beginning date (RBD) i.e. generally April 1 of the year after the participant attains age 70 . 1. If there is no designated beneficiary and the participant died before his RBD, the rules generally require the retirement plan balance be distributed by December 31 of the year that contains the fifth anniversary of the participants death the socalled 5 year rule. 2. If there is no designated beneficiary and the participant died after reaching his RBD, the distribution can be paid over what remains of the participants life expectancy. a. Unless the benefits are distributed to a surviving spouse (in which case the distribution can be rolled over to the spouses IRA) or charity, the distribution will be subject to income tax. B. However, if there is a valid designated beneficiary, the distributions may be paid over the beneficiarys life expectancy. If there is more than one designated beneficiary, the distributions must be made over the life expectancy of the oldest beneficiary unless the benefits have been segregated into separate accounts by September 30 of the year after the participants death. C. The general rule is that a designated beneficiary must be an individual. However, a trust may be named as the beneficiary of an IRA and still be treated as having a designated beneficiary for MRD purposes. Reg. 1.401(a)(9)-4, A-5. The rules permit you to look through a trust instrument and treat the trust beneficiaries as if

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they had been named directly as the IRA beneficiary if the following five requirements are met: 1. The trust must be valid under state law (or would be but for the fact that there is no corpus). 2. The beneficiaries of the trust (with respect to the trusts interest in the retirement plan benefits) must be identifiable from the trust instrument you must be able to ascertain who is the oldest beneficiary to be able to compute the MRD. Any power of appointment or trustee spray power under which older beneficiaries could be added to the trust at a later date violates this rule. 3. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner. 4. Certain documentation must be provided to the plan administrator. See documentation requirements, below. The IRA trustee or custodian is treated as the plan administrator. Reg. 1.408-8, A-1(h). Does this mean that where Mellon is the trustee of a trust that, in turn, is the beneficiary of an IRA of which Mellon is the trustee or custodian, the documentation requirements will be automatically satisfied? After all, Mellon as trustee or custodian of the IRA, will have possession of the trust of which it is trustee. 5. All beneficiaries of the trust must be individuals. a. Indirectly allowing IRA benefits to pass to the IRA owners estate via a trust provision that allows or directs the use of trust property to pay the IRA owners debts or probate expenses may be treated the same as naming the estate as a beneficiary with the result that the trust has no designated beneficiary. PLR 9809059. Thus, it may be advisable to amend the trust so it either prohibits the use of retirement benefits to pay debts or expenses or require that no such payments may be made from the retirement benefits on or after the designation date. D. In addition, there is an implied sixth rule no person may have the power to change the beneficiaries of the IRA after September 30 of the year after the year of the IRA owners death (the designation date). E. The relevant date for complying with these rules (except for the irrevocability requirement, which must be met as of the date of death and the documentation requirements which must be met by October 31 of the year after the owners death) is the designation date i.e. September 30 of the year after the IRA owners death. F. Penalty for noncompliance with the 5 trust rules the trust does not get to take IRA distribution over the life expectancy of the oldest trust beneficiary i.e. the trust is treated as having no designated beneficiary.

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1. In some cases, the trust may not have the ability to take retirement plan distributions payable to a trust over the trust beneficiarys life expectancy. For example, if a 401(k) plan is payable to a trust and the plan requires the benefits to be paid only in a lump sum after the participants death, complying with the five trust rules is irrelevant under the 401(k) plan provisions the only option is a lump sum distribution. G. Documentation requirements. 1. To satisfy the documentation requirements specified above, the trustee must give to the IRA administrator either (1) a copy of the trust instrument or (2) a list of trust beneficiaries. Reg. 1.401(a)(9)-4, A-6(b). a. The list of the beneficiaries must: i. Include contingent and remainder beneficiaries (as of September 30 of the year after the IRA owners death) and the conditions of their entitlement; Certify that the list is correct and complete; and Agree to furnish a copy of the trust instrument if requested. Reg. 1.401(a)(9)-4, A-6(b).

ii. iii.

2. The copy of the trust instrument or the list of beneficiaries must be furnished to the administrator by October 31 of the year after death, or October 31, 2003, if later. Reg. 1.401(a)(9)-4, A-6. H. The October 31 certification certifies who were the beneficiaries of the trust on the September 30 designation date. I. Generally speaking, the beneficiaries of the trust are treated as the beneficiaries of the IRA i.e. when a trust is a beneficiary of an IRA, you look through the trust and determine who are the beneficiaries of the trust. 1. Generally, distributions to an IRA beneficiary must commence by 12/31 of the year after the IRA owner dies. The minimum required distribution rules are complicated if an IRA is payable to a trust. In certain situations, the amount of the distributions may be accelerated resulting is a loss of income tax deferral. 2. If the IRA is payable to a surviving spouse, the surviving spouse can (1) roll the IRA to his or her own IRA, allowing the surviving spouse to defer mandatory required distributions until he or she attains his or her required beginning date or (2) leave the IRA in the deceased IRA owners name and delay minimum required distributions until the later of December 31 of the

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year after the IRA owner died or December 31 of the year the deceased IRA owner would have attained age 70 . If the IRA is payable to a trust (other than a conduit trust), the spouse generally cant do a rollover and commence distributions when he or she reaches his or her required beginning date or delay distributions until December 31 of the year the deceased IRA owner would have reached age 70 - even if the spouse is the sole beneficiary of the trust. Reg. 1.408-8, A-5(a); Rev. Rul. 2000-2, 2000-3 I.R.B. 305. 3. If there is more than one beneficiary of the trust, the multiple beneficiary rule applies unless there are separate shares i.e. IRA is paid out over the life expectancy of the oldest beneficiary. 4. In order to pay over the life expectancy of the oldest beneficiary of the trust, all of the trust beneficiaries must be individuals i.e. so-called designated beneficiary. Beware of trusts that have charitable beneficiaries. 5. The date to determine if the trust has a valid designated beneficiary is 9/30 of the year after the death of the IRA owner. 6. In determining the beneficiaries of the trust, you take into consideration both the present and contingent beneficiaries. The IRA would be payable over the life expectancy of the oldest of all the present and contingent beneficiaries. a. Exception: A contingent beneficiary is ignored if his ability to take is contingent on surviving a current beneficiary. Reg. 1.401(a)(9)-5, A-7(c). J. The distribution rules: 1. If the trust has valid designated beneficiaries, distributions from the IRA may be spread over the life expectancy of the oldest beneficiary. Use the single life expectancy table, no recalculation. 2. If the trust does not have valid designated beneficiaries: a. If the IRA owner dies before age 70 , the IRA must be completely distributed to the trust by 12/31 of the fifth year after the death of the IRA owner the so-called 5 year rule. b. If the IRA owner dies after 70 , the IRA must be distributed over the remaining life expectancy of the IRA owner, no recalculation. i. The use of age 70 is a misnomer the actual focal date is generally April 1 of the year after the IRA owner reaches age 70 . To simplify, this outline refers to age 70 .

3. Traps to be aware of

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a. Pay unsatisfied estate bequests from trust and will has unsatisfied charitable bequests b. Trust beneficiary has power of appointment and permissible appointee is a charity. c. Payment of debts, expenses out of trust in this case the estate may be deemed to be a trust beneficiary. An estate is not a valid designated beneficiary. VI. Retirement Equity Act of 1984 A. The Retirement Equity Act of 1984 may require a married participant who intends to name anyone other than his or her spouse as beneficiary of a qualified plan to obtain consent of the spouse. If a plan participant is married, naming a trust as the beneficiary of the proceeds of a qualified plan requires compliance with the participant waiver and spousal consent rules of IRC 401(a)(11) and 417. B If the participant dies before the participant begins receiving benefits under the plan, the participant's spouse has the right to receive a portion of the participant's benefit in the form of a qualified pre-retirement survivor annuity (QPSA), which provides for annual or more frequent payments for his or her lifetime. C. Once the participant begins receiving benefits under the plan, the benefits must be paid to the participant, and to the spouse if the spouse survives the participant, in the form of a qualified joint and survivor annuity (QJSA). The QJSA rules provide that annual or more frequent payments be made to the participant during his/her life and if the spouse survives, annual or more frequent payments would continue to the spouse for his/her life. 1. Certain profit-sharing plans are not required to provide QJSA payments, but all of the participants vested account balance must be paid to the participants surviving spouse if the participant dies before withdrawing the account balance. D. The participant waiver and spousal consent rules do not apply to IRAs. However, if the IRA is the result of a rollover from a qualified plan which did not meet the spousal consent rules, the surviving spouse may still have rights in the IRA under the Retirement Equity Act of 1984 i.e. the IRA is tainted. E. A married participant, with his or her spouses consent, may waive the right to the qualified preretirement survivor annuity if the participant dies before the participant begins receiving benefits, and to the right to have the participants benefit paid in the form of a qualified joint and survivor annuity once the participant begins receiving benefits. The plan benefits may then be received in some other form and be payable

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to a beneficiary other than the spouse. 417. The consent must be witnessed by a notary public or plan representative. F. The first step in naming a trust as the beneficiary of a qualified plan is to waive the annuity form of benefit and execute the spousal consent, if required. G. The participant would designate the trust as the beneficiary of some or all of the benefits available upon the participants death. H. Trustee of trusts named as beneficiaries of qualified plans or IRAs should make sure the requirements of the REA of 1984 have been met. Otherwise, the trust may discover that a spouse or former spouse has rights in the retirement plan assets that trump the trust. 1. If the waiver/consent rules were not followed, they can be satisfied after death as long as the document meets the requirement of both a waiver and a qualified disclaimer. GCM 39858.

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IRAs Payable to Trusts Administrative Complexities After Death

Jeremiah W. Doyle IV, Esq. Senior Vice President Mellon Financial Corporation Private Wealth Management Boston, MA May, 2006

Agenda/Topics
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Introduction Are Distributions Income or Principal? Fiduciary Income Tax Considerations Distributions Included in Trust/Estate DNI IRD and the 691(c) deduction Distributions to Charity and the 642(c) deduction Separate share rule and IRD - funding the subtrust Minimum Required Distributions Will NOT discuss: The 5 trust rules for qualifying as a DB QTIPping an IRA and Rev. Rul. 2000-2 Rul. 2000-

IRA Distribution to Trust

Avoid Lump Sum Distribution Triggers income tax, IRA deferral lost LSD may be the only option for qualified plan (401(k)) Take Distribution of MRD or Amount Needed Taxed on amount distributed, balance stays in IRA and enjoys tax deferral

IRA Distribution to Trust


$500,000 IRA

MRD or Amt Needed Trust

IRA Distribution to Trust

Is Distribution Income or Principal????

IRA Distribution to Trust

Trust instrument provisions govern Trust should define trust accounting income and how the definition applies to retirement plan assets Unfortunately, most trust instruments dont don

IRA Distribution to Trust

If trust instrument doesnt cover the issue, state law doesn applies In most states, look to Uniform Principal and Income Act (UPIA)

IRA Distribution to Trust - UPIA (1997)

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10% of required distribution is income, 90% is principal 100% of non-required distribution is principal nonUPIA applies only if trustee is unable to determine character of distribution earned by retirement plan and included in the distribution

IRA Distribution to Trust - UPIA (1997)


$500,000 IRA $10,000 Distribution $1,000 Income QTIP $1,000 Income Spouse $9,000 Principal

IRA Distribution to Trust

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IRA should use traditional trust accounting Trustee can intentionally cause beneficiary to be taxed on distributions by taking distribution from income Example: Doctor killed in boating accident, IRA payable to QTIP fbo spouse Spouse needed $50,000 distribution Mutual fund company IRA cause accounting problems

IRA

IRA Distribution

Trust distributes TAI to wife, trust gets income distribution deduction for amount distributed to wife

Income

Principal
Principal portion of IRA distribution taxed to trust

TRUST
Wife pays tax on TAI distributed from trust and may get portion of Section 691(c) deduction

Income SPOUSE

IRA

IRA Distribution

Trust distributes TAI and principal to wife, Income trust gets income distribution deduction for amount distributed to wife

Principal
Undistributed principal portion of IRA distribution taxed to trust

TRUST

Income SPOUSE

Principal

Wife pays tax on distribution from trust and may get portion of Section 691(c) deduction

$20,000 of MRD comes from accounting income of the IRA

IRA

IRA accounting income for 2002 is $35,000

$25,000 MRD for 2002

Income

Principal QTIP TRUST


$5,000 of MRD comes from principal of the IRA

Income

$35,000

SPOUSE

Result: Trustee must withdraw the $15,000 excess income ($35,000 less $20,000) from the IRA and pay it, along with the $20,000, to the wife

IRA Distribution to Trust - Tax Consequences


Fiduciary income tax rates (2006) compressed Trust/Estate reaches 35% bracket at $10,050 of TI M/J individual reaches 35% bracket at $336,550 of TI Relief from higher fiduciary income tax rates Distributions to individual beneficiaries in lower tax bracket Distribution to charity, get 642(c) deduction Possible 691(c) deduction

IRA Distribution to Trust - Tax Consequences

IRA distribution included in trust or estates estate distributable net income (DNI) as income in respect of a decedent (IRD) If distribution made, trust or estate gets an income distribution deduction and beneficiary includes distribution in income to the extent of DNI IRD taxed and the 691(c) deduction taken at the trust/estate level or beneficiary level, depending on distributions

IRA Distribution to Trust - Tax Consequences 3 Alternatives


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IRA accumulated taxed to trust/estate IRA completely distributed taxed to beneficiary IRA partially distributed taxation split between trust/estate and beneficiary

IRD Payable to an Estate or Trust Facts Reg. 1.691(c)-2


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Taxable interest IRD 691(c) deduction

$ 5,500 4,500 1,500

IRD Payable to an Estate or Trust Facts - Accumulation


IRA Distribution
Trusts Taxable Income: Trust Interest IRD Total 691(c) Exemption Taxable Income $ 5,500 4,500 10,000 ( 1,500) ( 100) 8,400

Trust

IRD Payable to an Estate or Trust Facts - $10,000 Distribution to Beneficiary


IRA Distribution
Trusts Taxable Income: Trust Interest IRD Total $ 5,500 4,500 10,000

Trust

$10,000

Distribution Deduction (10,000) 691(c) Exemption Taxable Income ( ( ( 0) 100) 100)

Beneficiary
Interest IRD 691(c) $5,500 4,500 1,500

IRD Payable to an Estate or Trust Facts - $2,000 Distribution to Beneficiary


IRA Distribution
Trusts Taxable Income: Trust Interest IRD Total $ 5,500 4,500 10,000

Trust

$2,000

Distribution Deduction ( 2,000) 691(c) Exemption Taxable Income ( 1,200) ( 100) 6,700

Beneficiary
Interest IRD 691(c) $1,100 900 300

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IRD Payable to an Estate or Trust Facts - Trust Distributes Right to IRD to Bene
Distribution of Right to IRD Right - No distribution deduction for trust - No income reported by Bene until receipt - Subchapter J distribution rules dont apply don Authority: Rollert Residuary Trust, Trust, 752 F.2d 1128 (6th Cir. 1985) PLRs 200234019 and 200452004 Assign Right to Right IRD Beneficiary Trust

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What is IRD???

Sec. 691(a) doesnt define IRD Regs define IRD as items which a decedent was entitled to prior to death but not included in his income before death

Deduction Provided To IRD Recipient for Estate Tax Attributable to IRD Taken as Misc. Itemized Deduction on Recipients Income Tax Return Not Subject to 2% Floor. Sec. 67(b)(7) Deductible For AMT Purposes. Sec. 56(b)(1)(A)(i) Will be subject to 3% haircut

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Compute FET Regular Way Recompute FET Excluding Net Value of IRD Net Value of IRD is Sec. 691(a) items less Sec. 691(b) items Difference is Estate Tax Attributable to IRD I.e. the Sec. 691(c) Deduction

FACTS
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John, A Widower, Dies At Age 65 in 2005 Has $2 Million IRA 2 Kids Named Beneficiary Of IRA

Jasper Gets 70%, Eloise Gets 30%

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John in Highest Income And Estate Tax Bracket Children Liquidate IRA Has R/E Taxes of $5,000 Owed but not Paid

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FET With IRD FET Without Net IRD Sec. 691(a) Items $2,000,000 Less: Sec. 691(b) Items ($5,000) $1,995,000 Net IRD FET Without Net IRD Sec. 691(c) Deduction

$1,707,030

($834,000) $873,030

IRD Recd During Year (Not over FET Value of Item) Estate Tax Value of All IRD (Sec. 691(a) Items)

Sec. 691(c) X Deduction =

Sec. 691(c) Deduction Allocated to Recipeint

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Jaspers Share of Sec. 691(c) Deduction:

$1,400,000 $2,000,000

X $873,030

= $611,121

Eloises Share of Sec. 691(c) Deduction:

$600,000 $2,000,000

X $873,030

= $261,909

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IRA TO ESTATE, ESTATE TO CHARITY IRA

Dont Make This Mistake !!!

ESTATE/ TRUST
Residue to charity

CHARITY

IRA TO ESTATE, ESTATE TO CHARITY IRA Two Problems: Estate not a Designated Beneficiary Fiduciary Income Tax Charitable Deduction???
Residue to charity

ESTATE/ TRUST

CHARITY

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IRA TO ESTATE, ESTATE TO CHARITY


Solutions: (1) Qualify for 642(c) Deduction (2) Assign IRA to Charity Assign (3) Pay the Charity Last (4) Bypass the Estate

IRA

ESTATE/ TRUST
Residue to charity

CHARITY

QUALIFY FOR 642(C) DEDUCTION


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2 Requirements for Fiduciary Income Tax Deduction: Paid out of gross income Paid pursuant to the governing document l Important: Estate or trust should have language that charitable gift can be satisfied by distribution of IRD l No distribution deduction

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IRA TO ESTATE, ESTATE TO CHARITY IRA

PLR 200336020 IRA distribution included in gross income of estate but qualified for fiduciary income tax charitable deduction.

ESTATE
Residue to charity

CHARITY

IRA TO ESTATE, ESTATE TO CRT IRA

No charitable deduction TAM 8810006 allows distribution deduction

ESTATE
Residue to CRT

CRT

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DISADVANTAGES OF CRT - PLR 199901023


WIFO Tier System of Taxation IRA Proceeds
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Tier One - Ordinary Income Tier Two - Capital Gain Tier Three - Tax-Exempt Income TaxTier Four - Return of Corpus

691(c)

What Really Happens: Section 691(c) Deduction Reduces the IRA Proceeds in Tier One Income

Assign IRA to Charity - PLR 200234019 (See also PLR 200452004) FACTS
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D named estate as beneficiary of IRA Ds will left percent of estate to various charities Will authorized non-pro rata distributions non Rev. Rul. 69-486 - no tax on non-pro rata Rul. 69nondistribution if allowed by inst or state law IRS says executor could assign IRA to charity assign Result: (1) No taxable income to estate or individual beneficiaries, (2) IRA not included in estates DNI and estate (3) No taxable income to charity Reason: Regs. say if IRD is transferred to specific or Regs. residuary legatee, only the recipient must report such income

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IRA TO ESTATE, ESTATE TO CHARITY IRA

Assign the IRA to charity

ESTATE
Residue to charity

CHARITY

Pay Charity Last - PLR 200221011 FACTS


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Ds will leaves specific bequests to individuals, residue to charity Estate named as beneficiary of IRA Year 1 - Executor pays administration expenses and all specific bequests to individuals Charity only remaining bene at end of Year 1 Year 2 - estate receives IRA proceeds Result: IRS says estate is entitle to charitable set aside deduction that would offset the inclusion of the aside IRA proceeds in gross income

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IRA TO ESTATE, PERCENT OF ESTATE TO CHARITY IRA

ESTATE
Residue to charity

CHARITY

IRD Payable to an Estate or Trust Funding Sub-Trusts


IRD Trust

Marital Trust

Family Trust

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Separate Share Rule Solely for purposes of computing DNI, substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts. Effect: Treat multiple beneficiaries of single trust or estate as if each were the sole beneficiary of a single trust solely for determining how much DNI each distribution carries out.

Separate Share Rule Result

A distribution will carry out DNI only to the extent there is DNI properly allocated to the beneficiarys separate share

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Issue: Application of Separate Share Rule to IRD Reg. 1.663(c)-2(b)(3)


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Final separate share regs provide that IRD is allocated among the separate shares that could potentially be funded with these amounts irrespective of whether the share is entitled to receive any income under the terms of the governing instrument or applicable local law. law. The amount of gross income allocated to each share is based on the relative value of each share that could potentially be funded with such amounts. amounts. Result: Allocation of IRD could shift income tax liabilities to trusts protected from Federal estate tax or GST. Docs should state that, to extent possible, applicable exclusion amount and GST exemption should be funded with non-IRD assets. non-

IRD Payable to an Estate or Trust Funding Sub-Trusts


$1,000,000 IRA $1,000,000 R/E IRA Marital Trust $1,000,000 (Fractional) Family Trust $1,000,000 Trust R/E

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IRD Payable to an Estate or Trust Funding Sub-Trusts


IRD not allocated to one share by document IRA Marital Trust Taxed on $500,000 of IRD Family Trust Taxed on $500,000 of IRD Trust R/E

IRD Payable to an Estate or Trust Funding Sub-Trusts


IRD allocated to Marital Trust by document IRA Marital Trust Taxed on $1,000,000 of IRD Family Trust Not Taxed on IRD Trust R/E

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IRD Payable to an Estate or Trust Affect on Fiduciary Income Tax Charitable Deduction
$1MM R/E $ 1MM IRA Trust

R/E

IRA Individual $1,000,000 $1,000,000 (Residuary or Fractional) Charity

IRD Payable to an Estate or Trust Affect on Fiduciary Income Tax Charitable Deduction
IRD not allocated to Charity by document R/E Trust Trust gets only $500,000 642(c) deduction IRA Individual $1,000,000 $1,000,000 (Residuary or Fractional) Charity

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IRD Payable to an Estate or Trust Affect on Fiduciary Income Tax Charitable Deduction
IRD allocated to Charity by document Trust gets $1,000,000 642(c) deduction IRA R/E Individual $1,000,000 $1,000,000 Charity

Trust

IRD Payable to an Estate or Trust Alternative - How to Avoid the Separate Share Rule
Have the Trust Assign the IRA Assign directly to the beneficiary. See PLRs 200234019 and 200452004 Individual $1,000,000 $1,000,000 (Residuary or Fractional) Trust gets $1,000,000 642(c) deduction Charity

Trust

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MINIMUM REQUIRED DISTRIBUTIONS Post Death Distributions


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Does trust qualify as DB? Five trust rules must be satisfied If trust qualifies as DB, distribution may be stretched over the LE of the oldest trust beneficiary
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Caution: Many qualified plans only allow LSD causing immediate taxation of entire amount

If payable to CRT, who cares about MRD? CRT exempt from income tax so IRA can be distributed to CRT in a lump sum

IRA PAYABLE TO TRUST

IRA

TRUST

BENEFICIARIES

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Trust as Designated Beneficiary: Five Requirements


1. Must be Valid Trust Under State Law 2. Trust is Irrevocable or Will, By Its Terms, Become Irrevocable at IRA Owners Death Owner 3. All Beneficiaries Must Be Individuals 4. Trust Beneficiaries Must Be Identifiable 5. Documentation Requirements Are Satisfied

Trust as IRA Beneficiary: Documentation Requirements


Give to Administrator at RBD: 1. Copy of Trust Instrument, or 2. List of Beneficiaries

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List of Beneficiaries:
1. Include contingent and remainder beneficiaries and condition of entitlement 2. Certify list is correct and complete 3. Update list if trust is amended 4. Furnish copy of trust upon demand

By 10/31 of the Year After Death: Final Beneficiary Certification


Furnish to Administrator: 1. Copy of Trust Instrument, or 2. Final List of Beneficiaries and Trust Instrument if Requested

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MINIMUM REQUIRED DISTRIBUTIONS Post Death Distributions


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Are there multiple beneficiaries? All beneficiaries must be DB i.e. individuals or qualifying trusts trusts If so, distributions taken over the LE of the oldest beneficiary In determining if there are multiple beneficiaries, you must consider consider both present and contingent beneficiaries. Contingent beneficiary is beneficiary ignored only if his ability to take is contingent on surviving the current the beneficiary. Reg. 1.401(a)(9)-5, A-7(c). PLR 200228025. Not an issue if 1.401(a)(9)- Aentire MRD required to be distributed to trust beneficiary then no amount will be accumulated for remaindermen. remaindermen.

MINIMUM REQUIRED DISTRIBUTIONS Post Death Distributions


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If there are multiple beneficiaries and not all are DB: Death before RBD: 5 year rule applies Death after RBD: Distribution over remaining LE of IRA owner (term certain basis)

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MINIMUM REQUIRED DISTRIBUTIONS Post Death Distributions


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Spouse loses out Cant do R/O or treat as own IRA (unless trust is a conduit trust) Can conduit
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Distributions must begin by 12/31 of year after death Cant be deferred until spouse reaches age 70 Can

Cant leave IRA in deceased IRA owners name and delay MRD until Can owner later of 12/31 of the year after the IRA owner died or 12/31 of the year the deceased IRA owner would have attained age 70 Cant recalculate spouses LE (unless the trust is a conduit trust) Can spouse conduit Cant do a stretch IRA i.e. leave to spouse and name kids as benes on Can IRA spouses death. MRD on IRA paid trust the same after spouses death spouse spouse

MINIMUM REQUIRED DISTRIBUTIONS Post Death Distributions


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Identity of DB not finalized until 9/30 of the year after death of IRA owner Allow post-mortem clean-up by: postclean- up
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Establishing separate account Distributions Disclaimers

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MINIMUM REQUIRED DISTRIBUTIONS Post-Death Distributions

IRA Owner Dies

9/30 12/31

2003

2004
Shake-Out Period

Conclusion
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Weve discussed We UPIA Fiduciary income taxation issues IRD 642(c) deduction Separate share rule Minimum required distributions

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